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Measures of Underlying Inflation Central Banks Consider


Posted: Monday, November 30th, 2020

Estimated Reading Time: 2 minutes

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Underlying inflation matters the most for central banks. They tend to exclude volatile components and have various forms throughout the developed world.

Since the Reserve Bank of New Zealand (RBNZ) first adopted an inflation-targeting framework, other central banks in the world followed. Nowadays, consensus exists that sustained economic growth needs a certain inflation level. Price stability, as such, refers to a certain level of inflation that does not hurt economic growth in the long run.

The European Central Bank (ECB) considers inflation below but close to 2% as its definition of price stability. On the other hand, the RBNZ looks at inflation between 1% and 3% in its definition of price stability. As such, inflation targeting varies from central bank to central bank, and, in some cases, the measures of underlying inflation vary as well.

Underlying Inflation

 

How Underlying Inflation Is Measured

The HICP or the Harmonized Index of Consumer Prices is the way the ECB measures price stability. The core measure the one that excludes volatile components matters the most.

In the United States, the Federal Reserve (Fed) looks at the annual percentage change in the total PCE deflator. Up until August this year, the 2% level over the long run served as a target for the underlying inflation. However, the Fed changed its inflation-targeting framework this year when it moved to Average Inflation Targeting (AIT). In this case, too, trimmed means, weighted median, and factor model are used to measure the underlying inflation as accurately as possible.

Now that the Fed shifted to average inflation around the 2% level, it means that it is willing to let inflation shooting higher. More precisely, the Fed’s decision implies that the federal funds rate will remain closer to the lower boundary longer.

Therefore, the Fed basically did nothing in the meantime, except delivering such forward-guidance in terms of its inflation targeting. However, from the moment it announced the change to AIT, the US dollar keeps falling against G10 currencies. More precisely, the Dollar index is in free falling and continues to make new lows. While the underlying inflation as measured by the PCE remains low, by simply shifting the inflation expectations, the Fed managed to influence the dollar’s value.

Consumer Price Index

Other major central banks in the world (e.g. Bank of England, Bank of Canada, Norges Bank, etc.), use the Consumer Price Index (CPI) as a measure of underlying inflation. They, too, consider price stability around the 2% level, although the exact definition differs from case to case.

No one likes inflation close to zero as it threatens a break into deflationary territory. Therefore, the better the central banks manage to measure the underlying inflation, the easier it becomes to reach their price stability goals.

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