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

2. Norges Bank Monetary Policy 2 Economics Department 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.” From The Regulation on Monetary Policy 29 March 2001

3. Norges Bank Monetary Policy 3 Economics Department 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.

4. Norges Bank Monetary Policy 4 Economics Department 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)

5. Norges Bank Monetary Policy 5 Economics Department CPI and various measures of core inflation 12 month growth. January 2002 – March 2006 Source: Statistics Norway Weighted median CPI-ATE 20 % trimmed mean CPI Inflation target

6. Norges Bank Monetary Policy 6 Economics Department 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

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

8. Norges Bank Monetary Policy 8 Economics Department 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

9. Norges Bank Monetary Policy 9 Economics Department Has the core measures been unbiased? Difference in mean of 12 month growth from headline CPI (core-cpi) Indicator1983-20051993-2005 CPI-ATE-0.18-0.34 Trimmed mean 20%0.00-0.04 Weighted median0.200.22 Excl. 10 % vol-0.06-0.17 Volatility weighted-0.050.09 Mean CPI3.652.03 Numbers in bold indicates that the difference was statistically significant

10. Norges Bank Monetary Policy 10 Economics Department Has the core measures been less volatile than CPI? Standard deviation of monthly changes in 12 month growth 1983-20051993-2005 CPI-ATE0.260.18 Trimmed mean 20%0.280.25 Weighted median0.410.32 Excl. 10 % vol0.290.24 Volatility weighted0.250.21 CPI0.430.47

11. Norges Bank Monetary Policy 11 Economics Department 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 Indicator1993-2004Demeaned CPI-ATE0.300.18 Trimmed mean 20%0.22 Weighted median0.520.47 Excl. 10 % vol0.290.26 Volatility weighted0.19 CPI0.72

12. Norges Bank Monetary Policy 12 Economics Department Can core inflation explain future changes in headline? Explanatory power (R 2 ) in regression equation. 6-24 months ahead. 6 m12 m18 m24 mAverage CPI-ATE0.420.580.280.170.36 Tr.m.(20\%)0.330.530.220.040.28 W.med.0.180.340.170.000.17 Excl. 10 % vol0.420.460.300.430.40 Volatility weighted0.360.520.380.360.40 Numbers in italics indicate that the relationship was not statistically significant.

13. Norges Bank Monetary Policy 13 Economics Department 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.