core inflation primer_june 2010

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Core Inflation

June 2010

Department of Economic Research 1

CORE INFLATION AND THE ESTIMATION OF CORE INFLATION

11.. What is core inflation?

Core inflation is a widely used measure of the underlying trend or movement in the averageconsumer prices. It is often used as a complementary indicator to what is known as

“headline” or Consumer Price Index (CPI) inflation.

22.. How is core inflation different from CPI or “headline” inflation?

Headline inflation refers to the rate of change in the CPI, a measure of the average price ofa standard “basket” of goods and services consumed by a typical family. In the Philippines,the CPI basket is composed of various consumer items as determined by the nationwideFamily Income and Expenditure Survey (FIES) conducted every three years by the NationalStatistics Office (NSO).

Headline inflation thus captures the changes in the cost of living based on the movementsof the prices of items in the basket of commodities and services consumed by the typical

Filipino household.

On the other hand, core inflation measures the change in average consumer prices afterexcluding from the CPI certain items with volatile price movements. By stripping out thevolatile components of the CPI, core inflation allows us to see the broad underlying trend inconsumer prices. Core inflation is often used as an indicator of the long-term inflation trendand as an indicator of future inflation. It is usually affected by the amount of money in theeconomy relative to production, or by monetary policy.

3.7

3.9

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Year-on-Year Core

Year-on-Year Headline

Headline and Core Inflation Year-on-Year Change in Percent

(2000=100)


(2000=100)

June 2010

33.. Why do we need to measure core inflation?

In many countries, CPI inflation is often influenced by factors beyond the control ofeconomic policy and has tended to be historically volatile. Shocks or disturbances in



Core Inflation

June 2010


certain areas of the economy may cause it to temporarily move away from its long-termtrend.

In the Philippines, the volatility of inflation has been caused by factors such as disturbancesin agricultural food supply or movements in international oil prices. As a result, the headlineinflation rate may reach double-digit levels, even though the prices of other CPI

components show only mild increases.

Core inflation is an indicator of the underlying movement in consumer prices since it takesout the effect of temporary disturbances and shocks that cause prices to surge or decline,independent of economic and monetary policy. Measuring core inflation helpspolicymakers determine whether current movements in consumer prices represent short-lived disturbances or are part of a permanent trend. Such knowledge is important to theformulation of economic policy, particularly monetary policy.

44.. How is core inflation measured or computed?

There are several methods used to compute core inflation. The most common approach

used in many countries is the exclusion method, which computes core inflation by takingout the prices of a fixed, pre-specified set of items from the CPI basket. The excludedcomponents are considered to be either volatile or susceptible to supply disturbances andtypically consist of food and energy items. This is based on the notion that the marketsrelated to these goods are prone to supply shocks.

Some economists advocate the use of statistically-based methods that remove extreme oroutlier price changes (both positive and negative) from the overall inflation rate. The set ofexcluded items changes each month, depending on which particular items exhibit extremeprice movements. The most common statistical measures of core inflation are the trimmedmean and weighted median. Both measures are derived from a highest-to-lowest (orpositive to negative) ranking of individual price changes for each given month. Thetrimmed mean measure takes the average inflation rate after excluding a specified

percentage of extreme positive and negative price changes, while the weighted mediansimply takes the median inflation rate which corresponds to a cumulative CPI weight of 50percent from the highest-to-lowest ranking.

It is also possible to use econometric techniques to estimate core inflation by estimating orcalculating a statistical relationship between inflation and other relevant economicvariables. The estimated regression model is then used to generate monthly estimates ofcore inflation using actual data for the other variables in the model.

In the Philippines, the official core inflation measure is computed using the exclusionmethod. This approach was chosen for the following reasons: ease of construction;understandability by the general public; easy replication and verification by others;increased accountability and transparency of measurement; and timeliness. Answers to

question nos. 9-10 provide a more detailed explanation on the choice of core inflationmeasures. Answer to question no. 12 provides a numerical example.



Core Inflation

June 2010


CROSS-COUNTRY EXPERIENCES ON CORE INFLATION

55.. Do other countries monitor core inflation?

Yes, most statistical authorities in other countries publish a measure of core inflation.Among central banks, it has become a common practice to monitor core inflation,

irrespective of the monetary policy framework being used. For example, non-inflationtargeting central banks such as the US Federal Reserve, the Bank of Japan and theMonetary Authority of Singapore also monitor core inflation.

66.. How do other countries measure core inflation?

The majority of countries employ the exclusion method and define core inflation as theoverall price index net of the effects of shocks such as policy changes (involving taxes forinstance), exchange rate, interest rate, and items which exhibit seasonal patterns. Themost common items excluded are food and energy since these items are consideredtraditionally as volatile components of the overall CPI basket. Canada, for example,excludes food, energy and the effects of indirect taxes, while the US excludes food and

energy. Thailand’s core inflation measure excludes raw food and energy prices, while theUnited Kingdom and New Zealand exclude only interest charges. Peru excludes 9 volatileitems—including food, fruits and vegetables, and urban transport—comprising about 21.2percent of the CPI basket. Meanwhile, Chile uses a statistical-based approach andestimates its core measure by excluding both the largest 20 percent of negative pricechanges and the largest 8 percent of positive price changes.

The table below summarizes the official core inflation measures adopted by other countriesas well as the other core inflation measures used internally by their central banks.

Country Official Core Measure Other Measures UsedInternally

by Central Banks

Canada CPI excluding Food, Energy andIndirect Taxes

CPI excluding 8 most volatileitems (16%)Weighted MedianTrimmed Mean (15%)

Thailand CPI excluding Fresh Food andEnergy (23%)

Trimmed Mean (10%)

Australia Treasury underlying CPI Trimmed meanWeighted Median

New Zealand CPI excluding interest chargesSingapore CPI excluding costs of private

road transport and costs ofaccommodation

CPI excluding volatile items(30%)Weighted Median

Trimmed Mean (15%)Structural Vector Autoregression(VAR) model estimate

Japan CPI excluding Fresh Food

Peru CPI excluding 9 volatile items(food, fruits and vegetables, andurban transport, about 21.2 %)



Core Inflation

June 2010



by Central Banks

United States CPI excluding food and energy

United Kingdom Retail price index excludingmortgage interest Rates (RPIX)

Weighted medianTrimmed mean (15%)

Chile CPI excluding 20% with higher (-)variations and 8% with higher (+)variations

Colombia CPI excluding agricultural food,public services, and transport

Germany CPI excluding indirect taxes

Spain CPI excluding energy andunprocessed food (IPSEBENE)

Netherlands ULI minus fruits, vegetables, andenergy

Ireland CPI (ULI 1) less mortgageinterest payments (MIPS)

CPI (ULI 2) excluding MIPS andfood and energyPortugal CPI (ULI) less unprocessed food

and energy

77.. How do policymakers use core inflation in other countries?

Most statistical agencies in other countries use core inflation as a supplementary indicatorto headline inflation and publish it alongside the headline rate. Some inflation targetingcentral banks—such as the central banks from Canada, Czech Republic, Finland, Thailandand South Africa—use core inflation as the operating target for monetary policy.

TOWARDS AN OFFICIAL DEFINITION OF CORE INFLATION IN THE PHILIPPINES

88.. Is there an official definition of core inflation in the Philippines?

Yes, there is an official definition of core inflation in the Philippines. The National StatisticalCoordination Board (NSCB) through NSCB Resolution No. 6 Series of 2003 adopted anofficial definition and methodology for computing core inflation in the Philippines based onthe exclusion method. Thus, while headline inflation is calculated as the year-on-yearchange in the overall CPI compiled by the NSO, the official core inflation measure isdefined as the rate of change of headline CPI after excluding selected food and energyitems.

99.. How was the official definition of core inflation determined?

The official definition is the result of inter-agency technical discussions among the NSO, theNSCB, the National Economic Development Authority (NEDA), the Statistical Research andTraining Center (SRTC), the National Wage and Productivity Commission (NWPC), theDepartment of Trade and Industry (DTI), and the Bangko Sentral ng Pilipinas (BSP).



Core Inflation

June 2010


1100.. Why was the exclusion method chosen for the official definition?

The exclusion method was chosen because: (a) it is easier to understand compared to theother methodologies; (b) it is more transparent and can be easily computed by anyone fromCPI data; (c) it can be produced by the NSO at the same time as the headline inflation rate;and (d) it is in accordance with the common international practice of excluding food- and

energy-related components of the CPI. Given that core inflation is a relatively new conceptfor the Filipino public in general, policymakers believed that the simplicity of the exclusionmethod can facilitate greater understanding by the public and consequently, help buildcredibility in the use of core inflation.

1111.. What specific items were excluded in order to compute for core inflation?

The items in the CPI that were excluded in the definition of core inflation components andtheir corresponding CPI weights (2000=100) are as follows:

• Rice (9.4 percent)

• Corn (0.9 percent)

• Fruits & Vegetables (5.3 percent)

• LPG (1.3 percent)

• Kerosene (0.3 percent)

• Oil, Gasoline and Diesel (1.3 percent)

Together, the above excluded items account for 18.4 percent of the CPI. The list ofexcluded items shall be reviewed by the NSCB Board and the Technical Committee onPrice Statistics (TCPS) whenever the CPI is rebased.

12. Is it possible to cite an example of the numerical computation of core inflation based on the official definition?

For illustration purposes, the following table presents a sample computation of core inflationfor December 2007. The core inflation rate for a given month (in this case December 2007)is the sum of core items’ inflation adjusted by the re-calibrated weights of these core items.



Core Inflation

June 2010


13. Which government agency generates the official core inflation data?

In February 2004, the NSO began publishing the official rate of core inflation, alongside theheadline inflation rate.

14. Will core inflation replace the current CPI or headline inflation published by the NSO?

No. Core inflation is not intended as a replacement for headline inflation, but as acomplementary indicator of the general movement in prices of goods and services.

15. Where does core inflation fit into the BSP’s inflation targeting framework?

Under the BSP’s inflation targeting framework, the annual inflation target is still defined interms of the headline inflation rate. The BSP uses the official measure of core inflation as acomplementary indicator of consumer price movements. Thus, it would serve as anadditional input to monetary policy analysis.

16. As a consideration in adjusting the minimum wages in the country, should Regional Wage Boards use core inflation rather than headline inflation?

No. Core inflation should not be used to represent the price developments variable, amongothers, as basis for adjusting wages in the country. Since the intention is to factor into thewage-fixing and adjustment decisions the general increases in the cost of living and lossesin purchasing power, the Regional Wage Boards should still use headline inflation. Wageadjustments must consider the price changes in all the items in the CPI basket, includingrice, corn and fuel-related items which are excluded in the computation of core inflation.

CONSUMER PRICE INDEX, PHILIPPINES (2000=100)

December 2007in percent

Dec 2007 Dec 2006

(1) (2) (3) (4)=(2) - (3) (5)=(4) / 81.6 (6) (7)(8) = ((6/7)-

1)*100

All Items 3.9 100.0 18.4 81.6 100.0 142.9 139.3 2.6

A. All Food Items 4.8 50.0 15.5 a 34.5 a 42.3 141.8 136.4 3.9

B. Clothing 1.6 3.0 0.0 3.0 3.7 125.6 123.6 1.6

C. Housing and Repairs 1.1 16.8 0.0 16.8 20.6 134.5 133.0 1.1

D. Fuel, Light and Water 5.3 6.9 1.5 b 5.4 b 6.6 165.7 167.1 -0.8

E. Services 4.9 15.9 1.3 c 14.6 c 17.9 160.1 155.0 3.3

F. Miscellaneous 1.3 7.3 0.0 7.3 9.0 123.2 121.6 1.3

1 The CPI weights are derived fr om each components' percentage share to the total personal consumption expenditure of a typical family, based o n data from the NSO's FIES.

(See Question No. 2)

n.b. - Figures may not add-up due to rounding offa Non-core items are rice, corn, fruits and vegetablesb excluding LPG and kerosenec excluding oil, gasoline and diesel

Weights in

Core CPI

Core

InflationCommodity

HEADLINE CORE

Core CPIInflation

RateWeights

1

Weights of

Non-Core

Items

CPI

Weights

Excluding

Non-Core

Items



Core Inflation

June 2010


NOTES



Core Inflation

June 2010


CORE INFLATION AND THE ESTIMATION OF CORE INFLATION

11.. What is core inflation?

Core inflation is a widely used measure of the underlying trend or movement in the averageconsumer prices. It is often used as a complementary indicator to what is known as

“headline” or Consumer Price Index (CPI) inflation.

22.. How is core inflation different from CPI or “headline” inflation?

Headline inflation refers to the rate of change in the CPI, a measure of the average price ofa standard “basket” of goods and services consumed by a typical family. In the Philippines,the CPI basket is composed of various consumer items as determined by the nationwideFamily Income and Expenditure Survey (FIES) conducted every three years by the NationalStatistics Office (NSO).

Headline inflation thus captures the changes in the cost of living based on the movementsof the prices of items in the basket of commodities and services consumed by the typical

Filipino household.

On the other hand, core inflation measures the change in average consumer prices afterexcluding from the CPI certain items with volatile price movements. By stripping out thevolatile components of the CPI, core inflation allows us to see the broad underlying trend inconsumer prices. Core inflation is often used as an indicator of the long-term inflation trendand as an indicator of future inflation. It is usually affected by the amount of money in theeconomy relative to production, or by monetary policy.

3.7

3.9

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Year-on-Year Core

Year-on-Year Headline


(2000=100)


(2000=100)

June 2010

33.. Why do we need to measure core inflation?

In many countries, CPI inflation is often influenced by factors beyond the control ofeconomic policy and has tended to be historically volatile. Shocks or disturbances in



Core Inflation

June 2010


certain areas of the economy may cause it to temporarily move away from its long-termtrend.

In the Philippines, the volatility of inflation has been caused by factors such as disturbancesin agricultural food supply or movements in international oil prices. As a result, the headlineinflation rate may reach double-digit levels, even though the prices of other CPI

components show only mild increases.

Core inflation is an indicator of the underlying movement in consumer prices since it takesout the effect of temporary disturbances and shocks that cause prices to surge or decline,independent of economic and monetary policy. Measuring core inflation helpspolicymakers determine whether current movements in consumer prices represent short-lived disturbances or are part of a permanent trend. Such knowledge is important to theformulation of economic policy, particularly monetary policy.

44.. How is core inflation measured or computed?

There are several methods used to compute core inflation. The most common approach

used in many countries is the exclusion method, which computes core inflation by takingout the prices of a fixed, pre-specified set of items from the CPI basket. The excludedcomponents are considered to be either volatile or susceptible to supply disturbances andtypically consist of food and energy items. This is based on the notion that the marketsrelated to these goods are prone to supply shocks.

Some economists advocate the use of statistically-based methods that remove extreme oroutlier price changes (both positive and negative) from the overall inflation rate. The set ofexcluded items changes each month, depending on which particular items exhibit extremeprice movements. The most common statistical measures of core inflation are the trimmedmean and weighted median. Both measures are derived from a highest-to-lowest (orpositive to negative) ranking of individual price changes for each given month. Thetrimmed mean measure takes the average inflation rate after excluding a specified

percentage of extreme positive and negative price changes, while the weighted mediansimply takes the median inflation rate which corresponds to a cumulative CPI weight of 50percent from the highest-to-lowest ranking.

It is also possible to use econometric techniques to estimate core inflation by estimating orcalculating a statistical relationship between inflation and other relevant economicvariables. The estimated regression model is then used to generate monthly estimates ofcore inflation using actual data for the other variables in the model.

In the Philippines, the official core inflation measure is computed using the exclusionmethod. This approach was chosen for the following reasons: ease of construction;understandability by the general public; easy replication and verification by others;increased accountability and transparency of measurement; and timeliness. Answers to

question nos. 9-10 provide a more detailed explanation on the choice of core inflationmeasures. Answer to question no. 12 provides a numerical example.



Core Inflation

June 2010


CROSS-COUNTRY EXPERIENCES ON CORE INFLATION

55.. Do other countries monitor core inflation?

Yes, most statistical authorities in other countries publish a measure of core inflation.Among central banks, it has become a common practice to monitor core inflation,

irrespective of the monetary policy framework being used. For example, non-inflationtargeting central banks such as the US Federal Reserve, the Bank of Japan and theMonetary Authority of Singapore also monitor core inflation.

66.. How do other countries measure core inflation?

The majority of countries employ the exclusion method and define core inflation as theoverall price index net of the effects of shocks such as policy changes (involving taxes forinstance), exchange rate, interest rate, and items which exhibit seasonal patterns. Themost common items excluded are food and energy since these items are consideredtraditionally as volatile components of the overall CPI basket. Canada, for example,excludes food, energy and the effects of indirect taxes, while the US excludes food and

energy. Thailand’s core inflation measure excludes raw food and energy prices, while theUnited Kingdom and New Zealand exclude only interest charges. Peru excludes 9 volatileitems—including food, fruits and vegetables, and urban transport—comprising about 21.2percent of the CPI basket. Meanwhile, Chile uses a statistical-based approach andestimates its core measure by excluding both the largest 20 percent of negative pricechanges and the largest 8 percent of positive price changes.

The table below summarizes the official core inflation measures adopted by other countriesas well as the other core inflation measures used internally by their central banks.


by Central Banks

Canada CPI excluding Food, Energy andIndirect Taxes

CPI excluding 8 most volatileitems (16%)Weighted MedianTrimmed Mean (15%)

Thailand CPI excluding Fresh Food andEnergy (23%)

Trimmed Mean (10%)

Australia Treasury underlying CPI Trimmed meanWeighted Median

New Zealand CPI excluding interest chargesSingapore CPI excluding costs of private

road transport and costs ofaccommodation

CPI excluding volatile items(30%)Weighted Median

Trimmed Mean (15%)Structural Vector Autoregression(VAR) model estimate

Japan CPI excluding Fresh Food

Peru CPI excluding 9 volatile items(food, fruits and vegetables, andurban transport, about 21.2 %)



Core Inflation

June 2010



by Central Banks

United States CPI excluding food and energy

United Kingdom Retail price index excludingmortgage interest Rates (RPIX)

Weighted medianTrimmed mean (15%)

Chile CPI excluding 20% with higher (-)variations and 8% with higher (+)variations

Colombia CPI excluding agricultural food,public services, and transport

Germany CPI excluding indirect taxes

Spain CPI excluding energy andunprocessed food (IPSEBENE)

Netherlands ULI minus fruits, vegetables, andenergy

Ireland CPI (ULI 1) less mortgageinterest payments (MIPS)

CPI (ULI 2) excluding MIPS andfood and energyPortugal CPI (ULI) less unprocessed food

and energy

77.. How do policymakers use core inflation in other countries?

Most statistical agencies in other countries use core inflation as a supplementary indicatorto headline inflation and publish it alongside the headline rate. Some inflation targetingcentral banks—such as the central banks from Canada, Czech Republic, Finland, Thailandand South Africa—use core inflation as the operating target for monetary policy.

TOWARDS AN OFFICIAL DEFINITION OF CORE INFLATION IN THE PHILIPPINES

88.. Is there an official definition of core inflation in the Philippines?

Yes, there is an official definition of core inflation in the Philippines. The National StatisticalCoordination Board (NSCB) through NSCB Resolution No. 6 Series of 2003 adopted anofficial definition and methodology for computing core inflation in the Philippines based onthe exclusion method. Thus, while headline inflation is calculated as the year-on-yearchange in the overall CPI compiled by the NSO, the official core inflation measure isdefined as the rate of change of headline CPI after excluding selected food and energyitems.

99.. How was the official definition of core inflation determined?

The official definition is the result of inter-agency technical discussions among the NSO, theNSCB, the National Economic Development Authority (NEDA), the Statistical Research andTraining Center (SRTC), the National Wage and Productivity Commission (NWPC), theDepartment of Trade and Industry (DTI), and the Bangko Sentral ng Pilipinas (BSP).



Core Inflation

June 2010


1100.. Why was the exclusion method chosen for the official definition?

The exclusion method was chosen because: (a) it is easier to understand compared to theother methodologies; (b) it is more transparent and can be easily computed by anyone fromCPI data; (c) it can be produced by the NSO at the same time as the headline inflation rate;and (d) it is in accordance with the common international practice of excluding food- and

energy-related components of the CPI. Given that core inflation is a relatively new conceptfor the Filipino public in general, policymakers believed that the simplicity of the exclusionmethod can facilitate greater understanding by the public and consequently, help buildcredibility in the use of core inflation.

1111.. What specific items were excluded in order to compute for core inflation?

The items in the CPI that were excluded in the definition of core inflation components andtheir corresponding CPI weights (2000=100) are as follows:

• Rice (9.4 percent)

• Corn (0.9 percent)

• Fruits & Vegetables (5.3 percent)

• LPG (1.3 percent)

• Kerosene (0.3 percent)

• Oil, Gasoline and Diesel (1.3 percent)

Together, the above excluded items account for 18.4 percent of the CPI. The list ofexcluded items shall be reviewed by the NSCB Board and the Technical Committee onPrice Statistics (TCPS) whenever the CPI is rebased.

12. Is it possible to cite an example of the numerical computation of core inflation based on the official definition?

For illustration purposes, the following table presents a sample computation of core inflationfor December 2007. The core inflation rate for a given month (in this case December 2007)is the sum of core items’ inflation adjusted by the re-calibrated weights of these core items.



Core Inflation

June 2010


13. Which government agency generates the official core inflation data?

In February 2004, the NSO began publishing the official rate of core inflation, alongside theheadline inflation rate.

14. Will core inflation replace the current CPI or headline inflation published by the NSO?

No. Core inflation is not intended as a replacement for headline inflation, but as acomplementary indicator of the general movement in prices of goods and services.

15. Where does core inflation fit into the BSP’s inflation targeting framework?

Under the BSP’s inflation targeting framework, the annual inflation target is still defined interms of the headline inflation rate. The BSP uses the official measure of core inflation as acomplementary indicator of consumer price movements. Thus, it would serve as anadditional input to monetary policy analysis.

16. As a consideration in adjusting the minimum wages in the country, should Regional Wage Boards use core inflation rather than headline inflation?

No. Core inflation should not be used to represent the price developments variable, amongothers, as basis for adjusting wages in the country. Since the intention is to factor into thewage-fixing and adjustment decisions the general increases in the cost of living and lossesin purchasing power, the Regional Wage Boards should still use headline inflation. Wageadjustments must consider the price changes in all the items in the CPI basket, includingrice, corn and fuel-related items which are excluded in the computation of core inflation.

CONSUMER PRICE INDEX, PHILIPPINES (2000=100)

December 2007in percent

Dec 2007 Dec 2006

(1) (2) (3) (4)=(2) - (3) (5)=(4) / 81.6 (6) (7)(8) = ((6/7)-

1)*100

All Items 3.9 100.0 18.4 81.6 100.0 142.9 139.3 2.6

A. All Food Items 4.8 50.0 15.5 a 34.5 a 42.3 141.8 136.4 3.9

B. Clothing 1.6 3.0 0.0 3.0 3.7 125.6 123.6 1.6

C. Housing and Repairs 1.1 16.8 0.0 16.8 20.6 134.5 133.0 1.1

D. Fuel, Light and Water 5.3 6.9 1.5 b 5.4 b 6.6 165.7 167.1 -0.8

E. Services 4.9 15.9 1.3 c 14.6 c 17.9 160.1 155.0 3.3

F. Miscellaneous 1.3 7.3 0.0 7.3 9.0 123.2 121.6 1.3

1 The CPI weights are derived fr om each components' percentage share to the total personal consumption expenditure of a typical family, based o n data from the NSO's FIES.

(See Question No. 2)

n.b. - Figures may not add-up due to rounding offa Non-core items are rice, corn, fruits and vegetablesb excluding LPG and kerosenec excluding oil, gasoline and diesel

Weights in

Core CPI

Core

InflationCommodity

HEADLINE CORE

Core CPIInflation

RateWeights

1

Weights of

Non-Core

Items

CPI

Weights

Excluding

Non-Core

Items



Core Inflation

June 2010


NOTES

core inflation primer_june 2010

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