RDP 2006-10: The Performance of Trimmed Mean Measures of Underlying Inflation 6. Assessment of Recent Underlying Inflation

Given that 10 or more years of monthly and quarterly data suggest that the trimmed means perform well against the various criteria in Section 5, we now look at the picture they provide about recent developments in inflation, during a period – until late 2006 – in which rising oil prices have boosted headline CPI inflation.

There has been significant debate over how to think about the effect of rising oil prices, with some central banks focusing mostly on exclusion measures, but others looking more at headline inflation. One justification for the latter stance is that rising oil prices have been caused in large part by the growth in demand for oil from China and other emerging markets. Yet the growth of these countries has also resulted in falls in prices of a range of manufactured goods, and it would seem inappropriate to leave out one effect that is boosting headline inflation while leaving in the effect that is reducing inflation. Fortunately, the trimmed mean measures can deal even-handedly with these two effects, by down-weighting potential outliers at both ends of the distribution.

In Figure 10 three measures of annual inflation are shown: headline CPI inflation, the traditional exclusion measure and a trimmed mean measure based on cumulated monthly or quarterly changes. Since we have demonstrated that a broad range of trims performs similarly well as measures of underlying inflation, rather than attempt to determine ‘optimal’ trims, we simply use the 25 per cent trim, the midpoint of all feasible trims. For the United States, the trimmed mean measure is based on the disaggregated regional data for implicit rents.

In general, annual headline CPI inflation has been running above the other measures in recent years, while the exclusion measure of core inflation has typically been lowest; the trimmed mean measure has tended to be between these two estimates. This result is not surprising given that the standard core measure excludes the significant impact from recent higher fuel prices. The trimmed mean measure also down-weights the impact of extreme price movements in fuel prices, but is symmetrical in the sense that in addition it down-weights the impact of prices that have fallen significantly. It is noteworthy that in all four economies the trimmed mean measures tend to provide less noisy measures of inflation than the two other measures. Overall, although the trimmed means suggest that underlying inflation has been running at a higher rate than is suggested by the more traditional exclusion measures of core inflation, they also suggest that, compared with the experience of the 1970s, inflationary pressures have remained generally well-contained in the face of a major shock to oil prices.