Saturday, May 1, 2010

The inflation index debate - core and headline inflation

Less than a year back, we were talking in alarming tones about a deflationary spiral in India and today, in a dramatic reversal of position, opinion makers are fretting about inflation getting out of control. While it is undeniable that there are dark clouds of inflation looming on the horizon, the clarity on the debates surrounding inflation could be considerably enhanced by reformulating the terms of the debate. In this context, Mostly Economics has this excellent explanation of the need for policy makers to also follow the core inflation rate.

One of the biggest challenges with clarifying the debate on price changes remains the construction of an inflation index that can be the least distortionary measure for use in formulating monetary policy.

In an excellent post Mark Thoma draws the distinction between today's inflation rate (or headline rate) and the long-run trend rate (or core inflation) of inflation. Though the former informs people of what is the rate at which prices are rising now, it has limited role in forming inflation expectations. But the later carries considerable significance to businesses (in their investment decisions), households (in their spending decisions), and policymakers (in monetary policy decisions), in so far as it informs them of the economic prospects for the future based on current growth trends. Central bankers in particular find the core inflation rate a more accurate predictor of future inflation rate.

Mark Thoma points to both empirical and theoretical ways to define such an index. The empirical definition involves a measure that best predicts future inflation (and therefore future interest rates) and also best represents the inflation rate faced by a typical consumer. The theoretical definition favors a measure that can be deployed in the dominant paradigm sticky prices macroeconomic models. On both these counts, the core inflation rate, which excludes food and energy prices, comes out as the preferred measure over the all-encompassing headline inflation rate.

Empirical analysis of inflation data across countries point to the fact that prices excluding food and energy prices (or core prices) are the most accurate measure of long-run trend rate of inflation. In other words, core inflation has been found to be a more accurate forecast of future inflation (pdf here) than the headline inflation rate. Further, the exclusion of food and energy prices helps strip out the transitory components and provides a more better estimate of the long-run inflation trend.

At a theoretical level, core inflation rate target, being relatively sticky (compared to food and energy prices), also best stabilizes the volatility in output, consumption and employment. As Mark Thoma writes,

"In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment). The rule will vary by model, but it usually involves a measure of output and a measure of prices, i.e. generally a Taylor rule type framework comes out of this process (a rule that links the federal funds rate to measures of output and prices).

However, in the Taylor rule, the best measure of prices to target is usually something that looks like a core measure of inflation. Essentially, when prices are sticky, which is the most common assumption in modern theoretical models, it’s best to target an index that gives most of the weight to the stickiest prices. That is, volatile prices such as food and energy are essentially tossed out of the index."

And to the extent that all policy making is based on some models, he has more justfication for using a core inflation rate

"In models with price and wage sluggishness (and all models make this assumption), it is the failure of prices to move quickly to clear markets that causes output to deviate from target. Thus, monetary policy makers need not be concerned with highly flexible prices, it is the sluggish prices that are the problem. The solution is to keep the problem (sluggish) prices as predictable as possible so that even if prices are set far in advance, they will remain optimal.

To do this, the sluggish prices must be stabilized - the flexible prices can take care of themselves. For policymakers, this implies that highly flexible prices such as food and energy can be removed from the index to isolate and highlight the problematic sluggish prices. The goal is not to find the index that best represents the cost of living, rather, the goal is to learn about current and expected future values of the index most useful for stabilization."

Apart from the core inflation which strips out the most volatile categories - food and energy - off the index permanently, alternative methods like the trimmed-mean method, used by the Federal Reserve Bank of Dallas in the US strips only the most volatile items off the index each month.

Unlike India, most other countries use the CPI-based core inflation rate, which is calculated once a month, to guide policymaking for both their central banks and governments. India, in contrast, relies on a weekly, WPI-based inflation rate.

However, its utility is limited to the present and contains limited information of the future. Its value lies in activiating the automatic social safety nets and other support measures to cushion those most vulnerable to food and energy price increases. It can also be argued that in any case, if the present headline inflation is on its way up on a sustained basis, it gets automatically transmitted into the core inflation figures.

In India, the year-on-year, point-to-point WPI-based inflation figures are released every week and it is a measure of the broad headline inflation at any particular time. It has a weightage of 22.02% for primary articles (foodgrains etc) and 14.23% for fuel, power, light and lubricants. A reflection of the volatility of this inflation figure is seen from the fact that it has risen from 1.5% in October 2009 to 9.9% in March 2010, on the back of steep increases in food prices.

Such sharp variations in the WPI figures arise from the fact that it measures the price change between two points - now and the same time last year - and in the process overlooks all of what happened over the year and between those two points. To that extent it is a simple point-to-point comparison of prices between now and the same time last year.

Further, such binary point comparison is also skewed by the base effect. This time last year, much of the debate was about avoiding a deflation (as inflatn slipped into negative territory in June) and even a liquidity trap. This in turn meant depressed prices and it is only natural that prices return to their trend rates. This naturally reflects in a more pronounced change (over a year) in prices and manifests in a higher inflation rate. All these make a strong case for abandoning the current point-to-point calculations and embracing an average measure that more accurately reflects the progression of prices throughout the year.

Since India does not have a reliable CPI-based non-food and energy inflation index, the closest measure of core inflation comes from the the changes in the prices of non-food manufacturing prices. Removing the primary articles, fuel products, and manufactured food products, the weight of the non-food manufactures in the WPI-based headline inflation index is about 52%.

Since November 2009, when it was negative 0.4%, India's core inflation rate has been rising sharply to 4.2% in February 2010 and 4.7% for March.

In view of its volatility and supply-side origins, there is very little that policy makers can do to address headline inflation trends. In contrast, the core inflation will give RBI and policy makers in New Delhi the most reliable information about the future trajectory of prices.

The problem with core inflation is that it becomes a misleading and lagging (to headline inflation) indicator during times of protracted increases in prices, and a monetary policy that follows it risks being "behind the curve". Further, steep and sudden variations in the other components, most notably house rents, can skew even the core inflation rates.

Update 1 (23/5/2010)
Paul Krugman sees core inflation as a measure of "inflation inertia".

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