In “Getting to the Core of Inflation” we read:
Over the past 26 years, we have reduced consumer price index (CPI) inflation and maintained it at a level close to our 2 per cent target, with no persistent episodes of inflation outside our inflation-control range of 1 to 3 per cent. Because inflation has been low, stable and predictable, Canadians have been able to make better economic decisions and achieve better economic outcomes.
That’s a solid track record, so, as you can imagine, it would take some compelling evidence for us to consider major changes to the policy.
Given its effectiveness, the renewals of the inflation-targeting agreement every five years have generally gone smoothly, but I can assure you they are not automatic. Because we are committed to having the best monetary policy framework for Canadians, we use the term of each agreement to conduct an intensive research and consultation program to critically examine aspects of the policy. For example, leading up to the 2016 renewal we investigated three questions:
- Is 2 per cent still the appropriate target for inflation?
- How do we incorporate financial stability considerations into the formulation of monetary policy?
- How should core inflation be used and measured?
Our research led us to conclude that the 2 per cent target is still appropriate and that monetary policy should be adjusted to address financial vulnerabilities only in exceptional circumstances.
Today, I want to focus on our findings on the third issue: the use and measurement of core inflation to assess the underlying trend of inflation. First, I’ll explain the purpose of core inflation measures in our policy deliberations and what we look for in reliable measures. Lastly, I’ll review the three new core measures we have adopted and what they are telling us about current inflationary pressures.
Until recently, there was headline CPI and CPIX, a measure of core that excluded eight (volatile) items from the Headline CPI:
In recent years, however, the usefulness of CPIX inflation as an operational guide for policy has deteriorated. Most notably, there have been large transitory shocks to CPI components not excluded from CPIX. Indeed, this highlights an inherent weakness in measures of core inflation such as CPIX, which include a fixed and pre-determined set of components.
In search of “perfection”, the Bank of Canada has decided to replace the core measure given by the CPIX with three new measures of core inflation:
After studying these alternatives, we decided to replace CPIX with three new measures of core inflation—CPI-trim, CPI-median and CPI-common. They perform well across a range of evaluation criteria. In particular, they allow the data to “speak” and thereby more accurately identify persistent movements in inflation that reflect the evolution of macroeconomic variables important to monetary policy (Chart 2).
Still, each measure was judged to have limitations, so we decided to use a set of measures, instead of relying on a single one. This underscores our view that monetary policy decisions should not be based on the mechanical use of such indicators. As policy-makers, we grapple with a high degree of uncertainty in estimating trend inflation and the output gap. Using multiple measures of core inflation helps us manage this uncertainty.
Let me describe the characteristics of each.
CPI-trim excludes CPI components whose prices in any given month have exhibited the most extreme movements. In particular, it trims off 20 per cent of the weighted monthly price variations at both the bottom and top of the distribution of price changes. It therefore always removes 40 per cent of the total CPI basket. These excluded components can vary from month to month, depending on which experience extreme movements at any given time. A good example would be the impact of severe weather on the supply and prices of certain food components.
CPI-median captures the price change located at the 50th percentile (in terms of the CPI basket weights) of the distribution of price changes in a given month. It helps filter out extreme price movements specific to certain components. Similar to CPI-trim, it eliminates all the weighted price variations at both the bottom and top of the distribution of price changes in any given month, except the price change for the component that is the midpoint of that distribution.
CPI-common is based on trends in price changes that are similar across the various categories in the CPI basket, rather than focusing on increases to specific items, such as the prices of gasoline or fruit. It uses a statistical procedure called a factor model to detect these common variations, which helps filter out price movements that might be caused by factors specific to certain components. Such common movements in prices are more likely to reflect underlying inflationary pressures related to aggregate demand and supply forces than sector-specific disturbances.
While headline inflation has swung widely, which can be confusing for monetary policymakers, how have these measures of core inflation performed? The charts indicate that, differently from the headline measure, they all have given much the same information about the trend rate of inflation.
Meanwhile, what really matters for the “good” behavior of the economy, a stable path of aggregate nominal spending (NGDP) growth, was disowned!
That metric indicates that the “quality of monetary policy” is getting poorer, even though the inflation target paradigm shows a “solid track record”!
In any case, after the gates were opened and nominal spending “ran away”, it´s too late devote resources to the perfection of core measures of inflation. If only Bernanke had paid attention to his own measure of core in 2008, both the US and Canada would be in a very different situation today.