Core inflation measures and the effectiveness: an interpretative model

Abstract

Monetary authorities speculate that by using core inflation measures it is possible to subdivide observed price variations into two components: a persistent component extended over a long time horizon and a short-term component representing transient shocks. The first type of variation is that which interests policy authorities, since it is controllable and goes by the name of core inflation (or underlying inflation). The second type of shock is outside of their control and goes by the name of the non-core component. Through a simple aggregate supply and demand model, we demonstrate that the success and effectiveness of a monetary policy in terms of price level stability depends on the extent to which inflation measures reflect long-term movements or include temporary shocks. In fact, if the inflation measure includes short-term effects, the task of controlling inflationary pressures becomes considerably more complicated. Indicators purified from transitory components identify core inflation but a common methodology for its calculation does not yet exist. There are, however, different approaches to identify core inflation which can be synthetically classified into two large groups: methods linked to the statistical approach that focus attention directly on the issue of how to measure core inflation from existing data; in methods linked to the modeling approach the estimates of inflation are instead conditioned by economic theory and are the result of an identification schema in which persistent elements are distinguished from temporary elements. Each method has its advantages and disadvantages and in practice, there is an inclination to base decisions on a battery of indicators, comparing the differences and evaluating them case by case.