RDP 2006-11: Component-smoothed Inflation: Estimating the Persistent Component of Inflation in Real Time 1. Introduction

Headline inflation is almost always the target for inflation-targeting central banks. But there is considerable interest in the use of underlying measures that are designed to reduce or remove transitory influences from the headline figure. The most commonly used measures of underlying inflation are those that exclude a few highly volatile items – typically fuel and food – from the headline measure. Other measures based on various statistical criteria, such as the trimmed mean or the weighted median of prices, have also been used in recent years.

This paper investigates an alternative measure of underlying inflation that addresses the problem of separating temporary from permanent shocks in a different way than existing measures. This measure, which we call component-smoothed inflation, estimates the separation between permanent and temporary shocks by using the information contained in the historical behaviour of individual price series. It is implemented by smoothing the historically noisy components of inflation while leaving the historically persistent components relatively untouched. This method has the advantage of allowing all items in the price index to retain expenditure weights in the underlying measure. It is designed to be sensitive to sustained relative price shifts and, consequently, to be unbiased with respect to headline inflation. It is also designed to be calculated in real time so that it can be used as a timely indicator of persistent inflation. A potential disadvantage is that when there are permanent shocks to series that have been historically volatile it will be slow to react to the shocks. These properties are discussed in more detail below. We calculate this measure for both Australia and the US to demonstrate its performance and highlight its characteristics.