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The ‘Core’ dilemma: More accurate measures of core inflation show it is ~200bps lower than what popular measures suggest
* While headline inflation is inarguably the most important determinant of interest rates, policymakers also track core inflation closely to assess persistent and underlying price pressures in the economy.
* In this report, we compare two classes of core inflation measures: Exclusion-based measures and trimmed means measures. Exclusion-based measures assume that prices of certain items are inherently volatile and exclude them from inflation calculation. Trimmed means measures, on the other hand, use empirical data to determine which items to exclude. Also, trimmed means measures cover larger share of the consumption basket compared with exclusion-based measures.
* We also propose a new method of calculating TM core inflation based on inflation standard deviation. This method removes items with highest inflation standard deviation over a defined period. It corrects a major flaw in traditional trimmed means method by ensuring consumption basket remains unchanged across the timeframe.
* Our analysis shows core inflation, as per more accurate ‘Trimmed Means’ method, is much lower than the more popular exclusion-based methods. In Apr ’19, core inflation (5% TM) was 2.9%, while as per traditional core (ex-food and fuel) gauge it was 4.5%. Also, core inflation based on 5% trimmed means averaged just 3.9% during FY19 as compared to 5.8% as per core (ex-food and fuel) gauge.
* This has significant implications for monetary policy. In the recent past, although headline inflation was subdued, MPC members often cited sticky and high core inflation to adopt a cautious approach to monetary policy. If MPC members had considered trimmed means based core inflation measures instead of exclusionbased measures, monetary policy could have turned dovish much sooner.
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