Constructing and evaluating core inflation measures from component‐level inflation data

Abstract

This paper undertakes a comprehensive examination of 10 measures of core inflation and evaluates which measure produces the best forecast of headline inflation out‐of‐sample. We use the Personal Consumption Expenditure Price Index as our measure of inflation. We use two sets of components (17 and 50) of the Personal Consumption Expenditure Price Index to construct these core inflation measures and evaluate these measures at the three time horizons (6, 12 and 24 months) most relevant for monetary policy decisions. The best measure of core inflation for both sets of components and over all time horizons uses weights based on the first principal component of the disaggregated (component‐level) prices. Interestingly, the results vary by the number of components used; when more components are used the weights based on the persistence of each component is statistically equivalent to the weights generated by the first principal component. However, those forecasts using the persistence of 50 components are statistically worse than those generated using the first principal component of 17 components. The statistical superiority of the principal component method is due to the fact that it extracts (in the first principal component) the common source of variation in the component level prices that accurately describes trend inflation over the next 6–24 months.

Modeling the Trend, Persistence, and Volatility of Inflation in Pacific Alliance Countries: An Empirical Application Using a Model with Inflation Bands

“…While the most common measure of core inflation is inflation excluding food and energy, some researchers propose more sophisticated methods (Cutler, 2001;Rangasamy, 2009;Crone et al, 2013;Shiratsuka, 2015;Gamber and Smith, 2019). Clark (2001) estimates US core inflation by organizing goods and services in the Consumer Price Index (CPI) into 36 categories between 1967 and 1997 and removing the eight most volatile ones.…”