Alternative indicators of core inflation for Norway

1. Alternative indicators of core inflation for Norway Einar W. Nordbø Norges Bank Geneva, 11.5. 2006 Economics Department

2. Monetary policy in Norway ”The operational target of monetary policy shall be annual consumer price inflation of approximately 2.5 per cent over time. In general, the direct effects on consumer prices resulting from changes in interest rates, taxes, excise duties and extraordinary temporary disturbances shall not be taken into account.” FromThe Regulation on Monetary Policy 29 March 2001 Economics Department

3. Background • The governmental regulation emphasizes that Norges Bank shall look through temporary disturbances to consumer prices. But what are ”temporary disturbances”? • Traditionally, Norges Bank has placed particular emphasis on CPI inflation adjusted for tax changes and excluding energy products (CPI-ATE) when assessing underlying inflation • This project: Development of alternative indicators of core inflation, and simple empirical evaluation of new and existing indicators. Economics Department

4. Various measures of core inflation • Permanently excluding particular components (food and energy, 8 most volatile, CPI-ATE) • Excluding on a period-by-period basis (trimmed means, weighted median) • Downplaying the influence of volatile items (weighted by volatility and persistence, double weighted) • Model based measures (Quah and Vahey, 1995, Bryan and Cecchetti, 1993) Economics Department

5. CPI and various measures of core inflation12 month growth. January 2002 – March 2006 CPI Weighted median Inflation target CPI-ATE 20 % trimmed mean Economics Department Source: Statistics Norway

6. Alternative measures of core inflation • Include all components, but give components that have been volatile in the past less weight (Edgeworth-index) • Exclude components that have been most volatile in the past Economics Department

7. CPI, CPI-ATE and alternative measures of core inflation. Economics Department Sources: Statistics Norway and Norges Bank

8. Empirical tests of core inflation • Number of tests proposed and used in the literature, but focus on some selected tests here. • core and headline inflation should have the same mean in the long run • core inflation should be less volatile than headline cpi • core inflation should track the longrun trend in headline cpi • the current deviation between core inflation should be a predictor of future changes in headline inflation Economics Department

9. Has the core measures been unbiased?Difference in mean of 12 month growth from headline CPI (core-cpi) Numbers in bold indicates that the difference was statistically significant Economics Department

10. Has the core measures been less volatile than CPI?Standard deviation of monthly changes in 12 month growth Economics Department

11. Has the measures tracked the longrun trend in CPI?Trend estimated as a 25 month centered moving average of headline cpi.Measured as mean square error Economics Department

12. Can core inflation explain future changes in headline? Explanatory power (R2) in regression equation. 6-24 months ahead. Numbers in italicsindicate that the relationship was not statistically significant. Economics Department

13. Summary of key findings • CPI-ATE performs reasonably well in the tests performed here, but its mean has been systematically below headline CPI. In particular due to the omission of energy prices. • Of the new measures, the volatility weighted indicator has promising results. But may be difficult to communicate, and constructed differently than CPI. • Different tests points to different indicators. General conclusion that there is no superior measure that performs well under all circumstances, and that the relationships may change over time. • The policy implication is that a central bank should monitor various measures of core inflation. Economics Department