Remarks by Lawrence Schembri
Deputy Governor of the Bank of Canada
Department of Economics, Western University
London, Ontario
09 February 2017
Getting to the Core of Inflation
Introduction
Thank you for the invitation to speak to you today.
In October, the Bank of Canada renewed its agreement on the inflation-control
target with the federal government for the sixth time since 1991.1 The target is a
critical component of our monetary policy framework, which also includes a
market-determined flexible exchange rate.
It's not often that a policy performs
better than expected. Our inflation-control
target did just that and continues to do so.
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
(Chart 1).2 Because inflation has been low, stable and predictable, Canadians
have been able to make better economic decisions and achieve better economic
outcomes. Consequently, real output has expanded at an average rate of close
to 2 1/2 per cent per year. In addition, there has been much less volatility in
inflation, interest rates and real GDP growth.
1
The inflation-control agreement between the Bank and the federal government was established
in 1991 and is renewed every five years. Canada was the second advanced economy to adopt
inflation targeting; New Zealand was the first. The 1991 agreement established a path for a
progressive reduction in the rate of inflation to 3 per cent by the end of 1992, 2 1/2 per cent by the
middle of 1994 and 2 per cent by the end of 1995. The target has remained at 2 per cent since
then.
2
CPI inflation has averaged 1.9 per cent since 1991.
I would like to thank Patrick Sabourin, Stefano Gnocchi and Laurence Savoie-Chabot
for their help in preparing this speech.
inflation has remained mostly within the Bank's
Chart 1: Since 1991,
operating band
Year-over-year percentage change, monthly data
%
14
12
10
8
6
4
2
0
-2
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014
Inflation-control range CPI inflation
Last observation: December 2016
Sources: Statistics Canada and Bank of Canada calculations
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:
1. Is 2 per cent still the appropriate target for inflation?
2. How do we incorporate financial stability considerations into the
formulation of monetary policy?
3. 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.3
Today, I want to focus on our findings on the third issue: the use and
I'll
measurement of core inflation to assess the underlying trend of inflation. First,
explain the purpose of core inflation measures in our policy deliberations and
I'll review the three
what we look for in reliable measures. Lastly, new core
measures we have adopted and what they are telling us about current
inflationary pressures.
Core Inflation "Core"?
Why Is
Let's start with the basics.
Inflation is simply a general increase in the average
price of goods and services over a given time period, in other words, a trend
increase in the cost of living.4 We measure inflation using the increase in total
CPI, which is estimated and published by Statistics Canada and tracks the cost
"shopping basket" of goods and services over time.5
of a representative fixed The
Bank of Canada officially targets the 12-month increase in the CPI because it is a
broad gauge of inflation that is most relevant to Canadians. It is essential that the
inflation target be widely understood and visible so that citizens can hold their
policy-making institutions accountable.
Our monetary policy framework posits that CPI inflation will be at 2 per cent on
an ongoing basis when actual output equals potential output. This is the level of
goods and services that an economy can produce and sustain without adding to
inflationary pressures.6 The difference between actual and potential output is the
output gap, which can be positive or negative.
We achieve our monetary policy target by helping align demand for domestically
produced goods and services with the economy's capacity to produce
them. If
aggregate demand is expected to exceed or fall short of the economy's potential
output, we typically raise or lower the policy interest rate to close the gap and
keep CPI inflation on target.
As much as we aim for low, stable and predictable inflation, there will always be
sharp movements in CPI inflation. These movements are generally driven by
volatility in the prices of a small number of goods and services. This volatility
typically has a transitory impact on the rate of inflation (most frequently, its
effects dissipate within a year). Since the effects of monetary policy on demand
have long and variable lags, the Bank must look ahead to achieve our inflation
over our policy horizon. Consequently, we "look through"
target short-lived price
changes by forecasting CPI inflation and the output gap beyond the horizon of
the impact of these price changes.7
If we reflexively raised our policy rate whenever inflation was above target and
lowered it whenever inflation was below target, we would end up reacting to a lot
This would lead to what has been called "instrument
of temporary factors.8
instability"-like trying to steer a car by constantly overcorrecting one way and
then the other. It would be counterproductive and would simply destabilize both
inflation and real economic activity. For this reason, many central banks use core
inflation measures, which are designed to help filter transitory deviations from
CPI inflation and therefore serve as a useful operational guide for policy. Such
measures help us estimate where the underlying trend of inflation is relative to
the target in the current month or quarter. They also help to corroborate other
indicators of capacity pressures (especially the output gap), which are uncertain.
Given this purpose, what criteria do we look for in an effective measure of core
inflation? We want a measure that (i) closely tracks long-run movements in CPI
inflation (in other words, one that is unbiased); (ii) is less volatile than CPI
inflation and captures persistent movements in inflation; (iii) is related to the
underlying macroeconomic determinants or drivers of inflation, particularly the
output gap; and (iv) is easy to explain and understand.
Now, let me describe how we measure core inflation.
The Limitations of CPIX
A common approach to measuring core inflation is to exclude items from the CPI
basket based on various criteria, such as their volatility.
The measure we used as an operational guide from 2001 until October 2016 is
CPIX, which strips out eight of the most volatile components of the CPI and
adjusts the remaining components for the effects of changes in indirect taxes.9
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. What to exclude is often evident
only after the fact. In the span of 12 months in the early 2000s, for example, the
inflation rate of automobile insurance premiums rose from 2.0 per cent to
30.6 per cent. At its peak, this one component of the CPI basket was adding a
full percentage point to CPIX inflation. Other components, such as electricity
prices, have also shown particularly high, but temporary, volatility, leading to
noticeable movements in CPIX inflation, while auto prices have, at times, moved
countercyclically, thereby obscuring the relationship between CPIX and the
deviation of actual from potential output.10
These three examples illustrate the flaw in simply excluding a fixed set of
components ex ante. In particular, adding more items to the list of exclusions
based on their observed price volatility, which may only be temporary, would not
solve the problem of how to account for unexpected spikes in the prices of other
components in the future. Moreover, it would reduce the number of components
tracked, rendering the core inflation measure less representative of household
consumption. More flexible approaches to estimating core inflation are needed.
The shortcomings in CPIX led us to evaluate the properties of a wide selection of
alternative measures of core inflation.11
Alternative 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
"speak" and thereby
data to 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.12
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.
captures the price change located at the 50th percentile (in terms of
CPI-median
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.13 Such common movements in prices are more likely to reflect
underlying inflationary pressures related to aggregate demand and supply forces
than sector-specific disturbances.
Chart 2: The three new measures of core inflation effectively filter out
volatile but temporary price changes
Year-over-year percentage change, monthly data
%
6
4
2
0
-2
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Range of preferred measures of core inflation CPI inflation
Last observation: December 2016
Sources: Statistics Canada and Bank of Canada calculations
Reliability of the Three New Core Measures
Of the various core measures we evaluated, we found CPI-trim, CPI-median and
CPI-common all met three of our four criteria: they were found to be roughly
unbiased, more persistent than CPI inflation and related to underlying
macroeconomic drivers, notably the output gap. CPI-common was the top
performer for two criteria: it was the most persistent and moved most closely with
the output gap. In addition, all three were relatively effective at looking through
sector-specific shocks. Two of the measures-CPI-median and CPI-common-
fell short on one criterion: they are relatively more difficult to explain and
understand than CPIX. I hope this speech and the supporting documentation
the Bank's and Statistics Canada's
available on websites will help in that regard.
Nonetheless, all the new measures performed better than CPIX for three main
reasons.
First, they are less influenced by sector-specific shocks and therefore more
accurate. In episodes such as the sharp rise in auto insurance premiums in the
early 2000s that I mentioned earlier, as well as the deflation in auto prices that
started in 2007 and the run-up in meat prices in 2014, CPIX was unable to filter
out these transitory shocks (Chart 3). The new measures were relatively more
effective at doing so.
It is important to note, however, that no measure of core inflation can filter out
every type of temporary shock that a central bank may wish to look through when
conducting monetary policy. In an open economy like Canada, for example,
currency movements can have a profound impact on consumer prices. A
movement in the exchange rate would have an effect on the level of prices for
imports and domestic import-competing goods and the persistence of this effect
would depend on the duration of the exchange rate movement, but its impact on
the rate of inflation would be much shorter. Thus, this exchange rate
passthrough (ERPT) effect would not warrant a policy response as long as inflation
expectations remain well anchored. The impact of ERPT does not typically reflect
changes in the underlying trend of inflation, which is affected by the degree of
excess capacity in the labour market and in the economy more broadly.14
At the same time, most measures of core inflation tend to be affected by ERPT in
varying degrees because they are sensitive to the relatively broad-based price
movements caused by ERPT in Canada. Still, on average, these measures were
found to have somewhat lower pass-through from the exchange rate compared
with CPIX. In particular, CPI-trim and CPI-common attach relatively more
importance than CPIX does to the prices of services, which are largely not traded
across borders.15
Second, the new core measures better capture persistent movements in inflation.
In other words, their movements endure across a number of periods, whereas
CPIX inflation shows no persistence.16 This implies that transitory price changes
are more predominant for CPIX than for the three new measures (Chart 3).
And third, the new measures have stronger relationships with key
macroeconomic drivers, such as the output gap. For example, the correlation with
the output gap is much higher for the new measures than with CPIX.17
Finally, it is important to note that, like CPIX, the three new measures are roughly
unbiased estimates of CPI inflation. Their averages from 1991 to 2016 are very
close to that of CPI inflation.18 Their outlooks will therefore converge to that of
CPI inflation over the policy horizon, as transitory factors dissipate.
Chart 3: The new measures of core inflation have shown they are more
effective than CPIX at looking through sector-specific shocks
Year-over-year percentage change, monthly data
%
4
Sharp rise in auto
3
Run-up in meat prices
insurance premiums
2
1
Deflation in auto prices
0
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Range of preferred measures of core inflation CPIX inflation
Sources: Statistics Canada and Bank of Canada calculations Last observation: December 2016
15
For CPIX, the weight on services is about 56 per cent, according to the 2013 Survey of
Household Spending. For CPI-trim, the higher relative importance attached to services could be
due to the fact that more goods prices are "trimmed" from the calculation
because their
movements are sharper and tend to reflect commodity price shocks. For CPI-common, this could
be because prices for services tend to move in tandem since they appear to be largely influenced
by labour market conditions and associated wage pressures, given that labour is typically the
most important input for the production of many services.
16
Although CPIX and the three new measures have similar variance over the 1991-2016 period,
CPIX is subject to much more short-term variability.
17
The correlation with the output gap for CPIX is 0.2; for the new measures it is 0.5-0.6. See
Bank of Canada, Monetary Policy Report, January 2017, Box 2, p. 12.
18
CPIX and the three new core inflation measures have an average of 1.8 per cent over this
period, which is the same as CPI inflation, excluding the effect of indirect tax changes.
Recent Evidence
Let's now look at how these new core measures have performed recently and
what they are telling us about ongoing inflationary pressures.
The three measures have generally evolved broadly in line over time, although
there have been instances when their behaviour has differed. For example, in the
fourth quarter of 2016 their range was relatively wide-between 1.4 and 2.1 per
cent (Chart 4).
To explore this behaviour, we based our analytical framework on the Phillips
curve.19 We assume that core inflation depends on the degree of excess capacity
in the economy and degree of ERPT.20 In the short run, inflation is also affected
by relative price changes and other temporary demand and supply shocks.21
Chart 4: The new measures of core inflation have diverged recently
Year-over-year percentage change, monthly data
%
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
CPI-trim CPI-median CPI-common
Source: Statistics Canada Last observation: December 2016
19
There are various ways to represent and estimate the Phillips curve. The framework used here
is based on a restricted backward-looking version of the Phillips curve. The constant in the
current framework represents the mean of the dependent variable (the selected measure of core
inflation), which is close to the official inflation target of 2 per cent and, as such, represents
relatively well-anchored expectations of inflation in the past.
20
Since exchange rate movements have been significant in recent years, our framework was
augmented to include the impact of ERPT. The impact of ERPT was derived using a bottom-up
approach for each measure.
21
Most prices are not very flexible in the short run. An increase in the price of one very important
good, such as gasoline, will typically not be immediately offset by small declines in all other
prices, and hence, the overall price level will rise. This will show up as an increase in the rate of
change of the price level: measured inflation.
These specific determinants are not included in the framework and are thus
captured empirically by the residual term.22
The new core measures are constructed to minimize the impacts of temporary
disturbances and relative price shocks, so they should, in principle, largely reflect
movements in excess capacity. Chart 5 shows the deviation from average of the
year-over-year percentage change in each measure since 2000 and the
decomposition of this deviation into three causes: excess capacity (or slack),
in the
ERPT, and an unexplained residual term ("others" chart). Let me say a few
words about each of these three elements.
First, excess capacity in the economy has had a material and persistently
negative impact on the three measures of core inflation since the Great
Recession.
Second, the depreciation of the Canadian dollar since mid-2014, largely driven
by the decline in commodity prices, has had a positive impact on all core
measures, although it has been diminishing since the beginning of 2016.
In the absence of ERPT and other unexplained factors, all three preferred
measures of core inflation would be below two per cent, broadly consistent with
the Bank's assessment of the degree of excess capacity in the Canadian
economy.
Third, while these macroeconomic determinants shed some light on the recent
evolution of all three measures, they are unable to fully account for the typically
temporary divergence among them at different times, including the recent one.
This can be seen in the positive residuals for CPI-trim and CPI-median in the
fourth quarter of 2016 and the negative residual for CPI-common. To shed a bit
more light on why the measures may diverge more markedly from time to time,
let me focus on the last three major occurrences: at the time of the Great
Recession in 2007-09, in 2012-13 and more recently.
During the Great Recession, the widening range can partly be explained by the
effects of the rapidly increasing excess capacity. In 2008Q4, all three were close
to 2.6 per cent. CPI-trim started to ease in 2009Q1, bottoming out at 1.2 per cent
in 2010Q1. CPI-common started a less pronounced descent a quarter later. This
is likely because excess capacity has a larger impact in the near term on
CPItrim than it does on CPI-common. The impact of excess capacity on
CPIcommon tends to be more delayed.23
The two most recent episodes of a larger divergence are more challenging to
explain. In 2012-13, CPI-trim eased from 1.5 per cent to roughly 1.0 per cent,
while CPI-median and CPI-common have remained closer to 1.5 per cent. In the
recent episode, CPI-common has been weakening more than the other two
measures. A closer look at the distribution of the price changes for all
55 components used as inputs to compute these core measures offers some
insights.
The distribution of the monthly price changes has not been symmetric in recent
years, particularly over these two periods, meaning that the negative shocks
affecting inflation have been more prevalent and more pronounced than positive
shocks. This likely reflects more-intense competition among Canadian retailers
during these two periods as well as ongoing excess capacity, which has
increased somewhat in the latest period, owing to the large negative commodity
price shock Canada has experienced since 2014. These factors have likely
lowered CPI-trim more than CPI-median over the past few years. CPI-trim, as a
weighted average, would be more affected by the asymmetries of shocks while
CPI-median would be more insulated from them.24
Chart 5: Deviation from the average core inflation for CPI-trim, CPI-median
and CPI-common
a. CPI-trim
Contribution to the deviation of the core inflation measure from its average, percentage points,
quarterly data
1.5 1.5
1 1
0.5 0.5
0 0
-0.5 -0.5
-1 -1
-1.5 -1.5
2000 2002 2004 2006 2008 2010 2012 2014 2016
Exchange rate pass-through Excess capacity Others CPI-trim
Note: Both the output gap and unit labour costs are included in excess capacity.
Last observation: 2016Q4
Sources: Statistics Canada and Bank of Canada estimates and calculations
b. CPI-median
Contribution to the deviation of the core inflation measure from its average, percentage points,
quarterly data
1.5 1.5
1 1
0.5 0.5
0 0
-0.5 -0.5
-1 -1
-1.5 -1.5
2000 2002 2004 2006 2008 2010 2012 2014 2016
Exchange rate pass-through Excess capacity Others CPI-median
Note: Both the output gap and unit labour costs are included in excess capacity.
Last observation: 2016Q4
Sources: Statistics Canada and Bank of Canada estimates and calculations
c. CPI-common
Contribution to the deviation of the core inflation measure from its average, percentage
points, quarterly data
1.5 1.5
1 1
0.5 0.5
0 0
-0.5 -0.5
-1 -1
-1.5 -1.5
2000 2002 2004 2006 2008 2010 2012 2014 2016
Exchange rate pass-through Excess capacity Others CPI-common
Note: Both the output gap and unit labour costs are included in excess capacity.
Last observation: 2016Q4
Sources: Statistics Canada and Bank of Canada estimates and calculations
Let me quickly summarize. These measures have declined since mid-2016 to
close to 2 per cent or below, in part, because of the diminishing effects of ERPT
and persistent excess capacity. The wide divergence among them in recent
years might reflect in some measure the prevalence of the negative price shocks
that have hit the economy. In addition, let me say that as policy-makers, we view
the divergence among the measures not as a weakness, but as an important
insight that validates our decision to use all three. If we had focused on just one,
we would have been led astray in our assessment of the underlying trend of
inflation.
Conclusion
Time to conclude. A key challenge we face as policy-makers working within an
inflation-targeting framework is to distinguish the trend from the transitory-that's
why measuring core inflation accurately is "core" to our approach. The better we
are at separating the two, the better we will be at understanding the current state
of the economy and capacity pressures, and the better we will be at achieving
our inflation target. Our ability to keep inflation on target is the means by which
the Bank and the target earn credibility and trust. That credibility gives Canadians
confidence and helps anchor their inflation expectations. This is a virtuous circle.
Having expectations solidly anchored is critical to conducting effective monetary
policy and achieving the target, especially in turbulent times such as the recent
Great Recession.
Although we've had
26 years of success in hitting our target, we are anything but
complacent. We are committed to learning from experience and from academic
research-including work conducted here at Western University-to continuously
improve our monetary policy framework. We used the period leading up to the
renewal of our target last year to update the framework by replacing CPIX with
three new core inflation measures, which give us a more effective reading of the
underlying trend of inflation. Using these multiple measures will also help us to
manage the measurement risk associated with any single indicator and to better
communicate the uncertainty involved in gauging inflationary pressures.
In our past quarterly Monetary Policy Reports (MPRs), we provided projections of
CPIX inflation and regularly described the extent to which movements in it were
due to sector-specific factors. However, we have come to realize that the
attention paid to CPIX inflation may have created the misperception that it was
the target for monetary policy rather than a useful operational guide. Going
forward, we have decided that only the projection for CPI inflation will be included
in the MPR to reinforce its role as the target for monetary policy. In addition, we
will focus our analysis on the key forces underpinning the inflation process. The
new core inflation measures will contribute importantly to this analysis.
In that regard, I want to emphasize that these measures are only one set of
inputs into our broad and ongoing assessment of pressures on capacity and
inflation. We also take into account a wide range of information, including
responses to our Business Outlook Survey and more informal conversations that
we conduct with businesses and other Canadians. We use a combination of
models and our own judgment to understand the underlying forces working on
inflation.
For many of you in this room, hearing about life in Canada before our inflation
target-when inflation and interest rates were in the double digits-must be as
difficult to imagine as life without laptops and smartphones. However, those of
you who are old enough to remember when mortgage interest rates hit 19 per
cent know first-hand how transformative the past 26 years of low and stable
inflation have been for family finances and for our economy. We understand that
Canadians want and expect low and stable inflation, and we are committed to
ensuring that we meet those expectations through the successful conduct of
monetary policy.