John Murray: Measuring inflation - methodology and misconceptions
Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Certified
General Accountants of Ontario, Toronto, 18 September 2008.
* * *
These past few months have been busy for central bankers, to say the least, and the past
few days are certainly no exception. While developments on Wall Street have garnered much
attention, the cost of living has also been an issue for us all, whether we're buying gas at the
pumps, booking an airline ticket, or just picking up a loaf of bread at the grocery store. Of
course, the cost of living is always front and centre for us at the Bank of Canada, where our
primary monetary policy objective is to ensure that inflation remains low, stable, and
predictable over the medium term. Some periods, however, are clearly more challenging
than others in terms of meeting this objective. To set effective policies in both tranquil and
turbulent times, we must understand what drives inflation and be able to anticipate its future
movements.
So tonight I'd like to talk in some depth about inflation: exactly what it is, how we measure it,
and how we gauge the underlying economic pressures that cause it to rise or fall. I'd
particularly like to discuss the Bank of Canada's "core measure" of inflation, and explain why
and how it is used by the Bank as an operational guide for monetary policy. I've chosen this
topic because of its timely nature, as we now see rising price pressures in various forms.
Along the way, I'd like to use this examination of core inflation to highlight for you just how
important the Bank's research is to the conduct of Canada's monetary policy. Innovative
research and analysis related to core inflation, like all our research efforts, underpin the
Bank's policy formulation and implementation of monetary policy, and contribute significantly
to our understanding of how the economy operates.
At this point, I should emphasize that the Bank consistently aims for low and stable inflation -
not for its own sake, but because it enhances the economy's performance. Aiming for an
explicit 2 per cent inflation target not only helps stabilize prices, it also helps stabilize real
output and employment, allowing the economy to grow at its maximum sustainable rate.
Experience has shown that this is the best contribution that monetary policy can make to the
economic welfare of Canadians.
Developments in inflation around the globe
Before I go into detail about particular Canadian measures and experiences with inflation, let
me take a step back to look at the larger, international picture. As I mentioned a moment
ago, Canadians have become increasingly aware of price pressures, but this is, in fact, a
global phenomenon. Indeed, sharp increases in inflation have been reported in both
advanced and emerging-market economies in recent months. It is true that world prices of
oil, natural gas, many minerals, and food products have eased in the past few weeks.
Nevertheless, earlier dramatic increases in the prices of these same commodities accounted
for sharp increases in inflation. In many cases, these have been some of the highest rates of
inflation observed in the past 10 to 15 years.
It is important to note that inflation performance varies widely across countries. In some
cases, excessively loose monetary policies, implemented in an attempt to push economic
growth higher than the sustainable limits of a country's production capacity, have also been
an important contributing factor.
In many countries, the recent surge in inflation has been coupled with a dramatic slowing in
real economic growth, rekindling memories of the 1970s and concerns over stagflation - the
uncomfortable combination of high inflation and slow or negative growth. Most observers
believe it would be too great a stretch to draw parallels between the current experience and
that of the 1970s. Still, recent developments do pose a serious policy challenge for central
bankers, especially when combined with the dislocation and difficulties evident in global
financial markets.
Conventional monetary policy reactions might not be appropriate in circumstances where we
see a combination of rising inflation, slowing GDP growth, and concerns about financial
instability. Rising inflation, for example, often leads to calls for tighter monetary policy. Yet,
would that be wise if a slowing economy and other developments were expected to reverse
these inflation pressures in the future? Slower economic activity often leads to calls for easier
monetary policy. But would that reaction be wise if inflation pressures were believed to be
rising rather than receding?
Around the world, monetary authorities are determined not to repeat the policy errors of the
1970s, when overly stimulative measures led to double-digit inflation and rising inflation
expectations. We all seek reliable indicators with which to gauge how serious and
longlasting the current inflation pressures might be. This kind of information can materially affect
the stance of monetary policy. This illustrates why monetary policy-makers must gather and
weigh as much information as possible in their decision making - and why inflation research
is so important.
Defining and measuring total and core CPI inflation
Before I describe some of our inflation research, let me give you some background on the
measures of inflation that we use at the Bank of Canada: measures based on Statistics
Canada's consumer price index (CPI). Inflation is, of course, defined as a persistent increase
in the average price of goods and services; in other words, a trend increase in the cost of
living. In the broadest terms, this is measured by the total, or headline, CPI, which tracks the
retail prices of a representative "shopping basket" of goods and services over time. It is also
the rate that the Bank of Canada officially targets for its monetary policy. Here I would remind
you that the Bank and the federal government have a formal agreement that sets out a target
of 2 per cent for the annual rate of increase in the CPI. As I said earlier, we pursue low and
stable inflation because it enhances the performance of the economy.
Yet, as much as we aim for low, stable, and predictable inflation, there will always be sharp
movements in total or headline inflation. These are generally driven by volatile price changes
in a small number of goods and services. In Canada, for example, fully 90 per cent of the
observed monthly variations in the CPI are linked to price changes in just 8 of the 54 major
goods and services categories included in the CPI. Further, these price changes are often
volatile and are often quickly reversed. They therefore add considerable "noise" to total CPI,
making it difficult to discern genuine movements in trend inflation.
For this reason, many central banks calculate core inflation measures, which are designed to
minimize the influence of the most volatile components of the CPI. Although opinions differ
among central bankers concerning the usefulness of core inflation measures, many
monetary authorities - including the Bank of Canada - find these measures helpful for two
important reasons. First, by focusing on the more stable components of the CPI,
policymakers are able to get a better fix on the underlying trend in inflation. This is important,
because monetary policy operates with long and variable lags. It can take as long as two
years before the full effect of a policy change is felt on inflation. Monetary policy must
therefore be forward-looking, focusing on a one- to two-year horizon. Any attempt to control
short-term movements in inflation is likely to prove to be counterproductive and will simply
destabilize both inflation and real economic activity. Core inflation can, therefore, serve as a
useful operational guide for policy by looking past these short-term price movements.
The second reason core inflation measures can be useful is that they can help anchor the
inflation expectations of businesses and households. Having an explicit 2 per cent target for
inflation, coupled with a strong commitment to achieve it, goes some distance towards
realizing this objective. But providing a reliable measure of core inflation that the public can
readily use to track trend movements in the CPI can strengthen the anchoring of
expectations by providing assurances that the Bank will not allow the rise in volatile
components to spread to other prices.
The Bank of Canada's core inflation measures
Now, let me talk about our core measures in detail. Measures of core inflation are usually
calculated in one of two ways. The "exclusion method" is the most straightforward and, as
the name suggests, involves excluding the prices of those goods and services that typically
display more than a predetermined amount of variability. The "reweighting method," in
contrast, doesn't exclude the prices of any goods and services. Instead, it assigns a weight to
each component that is inversely related to its volatility. In other words, more volatile price
series are given a lower weight.
The core inflation measure that the Bank of Canada currently uses is called CPIX and is
based on the exclusion method. It removes eight of the most volatile components of the total
CPI, as well as the effects of changes in indirect taxes such as the GST. The excluded items
in CPIX are fruit, vegetables, gasoline, fuel oil, natural gas, mortgage-interest costs, intercity
transportation, and tobacco products. It is important to note, however, that the Bank
calculates and monitors several different measures of trend inflation, not just CPIX. It uses
these, along with many other sources of information, as checks against its preferred core
measure. While all of the measures of trend inflation tend to move in a similar fashion, the
differences can be informative.
It is also worth noting that the Bank has changed its definition of core inflation over time, to
improve its reliability. When the Bank first began targeting inflation in 1991, the core inflation
measure it adopted was similar to that used by many other central banks and excluded all
food and energy prices. As a result, it was less inclusive than the current measure. After
gaining more experience, and through a process of extensive research and analysis, the
Bank refined its core inflation measure, as well as the set of additional measures that it
currently follows. In 2001, the Bank moved to CPIX because of its demonstrated superiority
on both empirical and theoretical grounds. Its advantage was confirmed by additional
research when our inflation targets were renewed again in 2006, and it has recently been
retested as part of a more comprehensive international study looking at a range of measures
of total and core inflation.
Clearly, this process of refinement and retesting never ends. This is because it is crucial that
we be able to determine the most effective indicators of underlying inflation and how these
might be further refined and improved upon over time. So the next question becomes: how
can we distinguish between good and bad measures? An effective core measure must have
four key properties. First, and most obviously, a core measure should be less volatile than
total inflation. Second, it must be unbiased. By this we mean that the core inflation measure
must track long-run movements in the total CPI very closely. Third, a good core measure
must also be a reliable predictor of future trend movements in the total CPI. Fourth, a good
core measure must be easy to understand and to explain to the public.
When all four requirements are considered together, CPIX has been shown to be as good
as, or better than, all of the alternative measures that the Bank might use. Other measures
may outperform CPIX when they are judged on just one or two of these four criteria. CPIW,
for example, which is calculated using the reweighting method, can give slightly better
predictions of the total CPI and bears a somewhat tighter relationship to the long-run trends
in the total CPI. These differences are very minor, however, and are offset by other
considerations such as ease of understanding. For this reason, CPIX is still the Bank's
preferred core measure. Nevertheless, given the demonstrated strengths of CPIW and one
or two other trend measures, the Bank continues to monitor a set of indicators rather than
relying on any single one.
Popular misconceptions about core inflation
Our choice of CPIX as an operational guide for monetary policy has, at times, been a source
of controversy and has led to several popular misconceptions. Journalists and other
interested observers frequently question the use of CPIX and other measures of trend
inflation as operational guides. They argue that such measures give an overly sanguine
picture of true inflation, especially during episodes of sharply rising food and energy prices.
Critics say that CPIX inflation is frequently lower than total CPI inflation because, they claim,
the Bank has stripped out the fastest-rising prices. These critics of CPIX argue that it doesn't
relate to the real-life experiences of typical households. "After all," they point out, "what
household doesn't buy food, drive a car, or have a mortgage?"
I'll respond to these criticisms with three related points. First, and most importantly, the
Bank's official target of 2 per cent inflation is based on total CPI inflation, not on CPIX. The
latter is only one of several indicators used to judge where the total CPI is likely to go in the
future. It is an important indicator that we use to judge what the inflation trends are, but it is
not our target.
Second, the Bank's decision to use core inflation as a policy guide is based exclusively on
empirical considerations. CPIX is used only because it has been shown to track future
movements in total CPI better than the past movements of the total CPI itself. If this were to
change, and if CPIX no longer outperformed the total CPI in this regard, we would stop using
it.
Finally, as noted earlier, it is critical that the Bank continue to focus on the future trend of CPI
inflation, as opposed to its current level, because monetary policy operates with such long
and variable lags. If the Bank were to react to every observed change in total CPI, it would
destabilize both inflation and real economic growth. It would be reacting to volatile changes
in a small subset of prices that would likely reverse course in the near future.
Is core always a better predictor than total CPI inflation?
Experience in Canada has shown that core inflation does outperform total inflation as an
operational guide for policy. When the two series deviate, total CPI inflation tends to
converge on core inflation rather than the reverse. Core inflation is therefore a better guide
as to where total inflation is going. This phenomenon might reflect the success that the Bank
has enjoyed over the past 17 years in keeping total CPI inflation close to its 2 per cent target.
When total inflation temporarily moves higher or lower than the target, households and
businesses know that it will probably return to target within a relatively short time.
Some countries haven't enjoyed the same positive experience. They've found that core
inflation tends to deviate persistently from total CPI inflation and is not a very reliable
measure of underlying inflation pressures. These differences have been documented
recently by researchers at the Bank, but they are not well understood.1 They appear to be
systematic in nature, as opposed to chance occurrences, and Bank researchers suspect that
they reflect differences in the way core inflation is defined, as well as structural differences in
the various economies. Such a situation isn't so surprising in less-developed countries and in
emerging markets; however, long-standing differences between core and total inflation have
also been observed in advanced countries. Core inflation measures tend to perform very well
in Australia, Canada, New Zealand, and the United States, for example, but they perform
poorly in the euro zone, Japan, and the United Kingdom. More research will be needed to
understand these differences.2
The Bank's successful use of core CPIX has helped anchor Canadian inflation expectations
which, in turn, has helped dampen movements in total inflation. If households and
businesses are convinced that inflation will soon return to 2 per cent, they are less likely to
form extrapolative expectations based on movements in current headline inflation.
Consequently, they are less likely to push prices higher or lower. This self-reinforcing cycle
makes the Bank of Canada's job much easier and is clearly beneficial for the economy as a
whole. Canada's strong performance on the inflation front over the past 17 years is a
testament to the usefulness of our inflation targets, our timely monetary policy actions, and
the supportive role played by core inflation measures.
Implications for Canadian inflation
So what is CPIX telling us about current price pressures in Canada? On the face of it, it
would seem to suggest that the underlying, or trend rate of inflation has recently been at
about 1.5 per cent. Although this measure is likely to rise modestly towards the end of this
year, it is still well below the headline or total CPI inflation rate, which has been running at
about 3.4 per cent. Because that 1.5 per cent core rate is also below the Bank's 2 per cent
target for inflation, can we assume that inflation in Canada is not much of a problem? I
wouldn't want to go that far, but the relatively low level of CPIX does provide at least some
reassurance that inflationary pressures are reasonably contained. Further, as we said in our
3 September interest rate announcement, we anticipate that certain temporary factors now
affecting both the total and CPIX measures of inflation should dissipate over the coming
quarters and that both measures will converge on 2 per cent in the second half of 2009. In
the interim, total CPI inflation is likely to continue rising, as past energy-price increases push
it higher. However, the recent decline in both spot and futures prices for energy commodities
means that the spike in total CPI inflation expected between now and the first quarter of 2009
will be lower than projected in July.
Seen from another perspective, does the current 1.5 per cent CPIX rate suggest that inflation
is too low, implying underlying economic weakness? I wouldn't want to make that assumption
either, because other trend measures suggest that underlying inflation is a touch higher than
2 per cent. Further, there is reason to believe that, over the most recent period, CPIX has
shown a very slight downward bias in its estimate of trend inflation. This is due to the higher
weight that it assigns to automobile purchases than some of the other trend measures do,
plus its exclusion of mortgage interest costs. This has been particularly apparent recently, as
auto prices have been falling over the past 12 months, while home-finance costs have been
rising faster than many other items in the CPI basket. I don't think this means that the CPIX
measure is no longer reliable; rather, this is likely a temporary situation. But it serves to
demonstrate why it is important to look at a range of indexes and to understand why they
may be moving differently.
Finally, I want to say a few words about inflation and monetary policy in the context of the
recent market turmoil in general, and the events of the past few days in particular. We know
from experience that inflation control works much more predictably when there are well-
functioning financial markets operating within a sound and stable financial system. While
markets in Canada have certainly been volatile in recent weeks, it is worth noting that strains
in Canadian credit markets have been considerably less intense than those seen in the
United States and elsewhere. The Bank is committed to supporting the efficient functioning of
financial markets, and earlier today, announced that it will enter into a $2-billion, 28-day term
purchase and resale agreement. The case for further operations will continue to be reviewed
in light of conditions in financial markets. Canadian banks have healthy balance sheets and
absolute leverage that is significantly lower than many of their international peers. They are
less exposed than their U.S. counterparts to the subprime-mortgage market that is at the root
of the market turmoil, and are less dependent on securitization for their financing and on
capital markets for their revenues.
Throughout this period of market turmoil, the Bank of Canada has remained in close contact
with policy-makers both in Canada and abroad, including colleagues in other major central
banks. We are closely monitoring global market developments, and will continue to provide
liquidity as required to support the stability of the Canadian financial system and the
functioning of financial markets.
Conclusion
There are four main messages that I would like you take away from this evening's
presentation. First, core inflation continues to be a useful operational guide for monetary
policy. Second, it is always combined with other information as a check on the current state
and future direction of trend inflation. Third, CPIX has not replaced the total CPI as our
official inflation target. It is simply a tool that helps us achieve our 2 per cent objective for
total CPI inflation. Finally, our continued research on this and other critical policy issues
makes a vital contribution to the Bank's ability to successfully carry out its responsibilities.
As I said off the top of my remarks, our research at the Bank has been crucial to the effective
conduct of Canada's monetary policy. Of course, our researchers continue to make a
contribution today as they explore the feasibility of new and innovative ways to calculate core
measures, as opposed to the standard exclusion and reweighting methodologies. Of course,
our researchers are working on many issues, which I don't have time to discuss now, but I do
encourage you to visit the Bank's website for more information.3
References
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Empirical Assessment", Bank of Canada Working Paper No. 2005-28.
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Core
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Review
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