Measures of Core Inflation: Experience from Malaysia

1. Measures of Core Inflation: Experience from Malaysia Muhamad Shukri, Abdul Rani Monetary Assessment & Strategy Department (Very Preliminary) SEACEN/IFC/BIS Workshop on Inflation Measurement: Central Bank Perspectives Tagaytay City, Philippines, 12-16 October 2009

2. Outline of Presentation • Why should monetary policy focus on core inflation? • Concepts of core inflation • Measures of core inflation at Bank Negara Malaysia • Exclusion-based method • Trimmed mean • Weighted median • Inverse variance • Core inflation at work • Lessons and observations

3. Recently, higher prices for major commodities shocked the global economy • Possible factors that could explain the increases in commodity prices: • Stronger demand from emerging markets (e.g. China & India) • Supply bottlenecks for the production of food commodities & crude oil • Adverse weather in major food producing countries (e.g. Australia) • Demand for grains for the production of bio-fuels • Geo-political constraints (esp. for crude oil production) • Selected commodities as hedging instruments against inflation (e.g. gold) or as a financial asset (wheat futures) Commodity Metals Price Index Commodity Food Price Index Crude Oil Price Index Source: IMF

4. Resulted in higher price volatility that hid important price signals Volatility = 12-month rolling standard deviation

5. Why should monetary policy focus on core inflation?

6. Outline of Presentation • Why should monetary policy focus on core inflation? • Concepts of core inflation • Measures of core inflation at Bank Negara Malaysia • Exclusion-based method • Trimmed mean • Weighted median • Inverse variance • Core inflation at work • Lessons and observations

7. Two Main Concepts of Core Inflation

8. Main elements of core inflation Persistence, demand pressures & expectations

9. Outline of Presentation • Why should monetary policy focus on core inflation? • Concepts of core inflation • Measures of core inflation at Bank Negara Malaysia • Exclusion-based method • Trimmed mean • Weighted median • Inverse variance • Core inflation at work • Lessons and observations

10. Exclusion-based method • Derived by permanently excluding certain components from the price index, a priori. • E.g. seasonal food and energy prices are often excluded on this basis. • Also excluded are price volatile items

11. Trimmed Mean • Calculated by excluding a certain percentage of the largest and smallest (weighted) price changes in components of the index. • Literature suggest trimming between 10-30%.

12. Weighted Median • Use all available (disaggregated) information from the consumer price index. • Items are arranged according to their rate of change. • The inflation at the median is considered as weighted median core inflation

13. Inverse Variance / Double Weighted • Core inflation is computed by assigning a new weight to each CPI component, which is inversely proportional to its volatility. • The new weight is derived by multiplying the original weight with the reciprocal of the standard deviation for each component across time. • This method lessen the effects of volatile items on aggregate inflation instead of eliminating them altogether.

14. Everything together

15. Each measure of core inflation was evaluated in order to determine their usefulness for policy analysis *Sample period: Jan 93-Dec 08, MAC = mean absolute change

16. Each measure of core inflation was evaluated in order to determine their usefulness for policy analysis *Sample period: Jan 93-Dec 08

17. Outline of Presentation • Why should monetary policy focus on core inflation? • Concepts of core inflation • Measures of core inflation at Bank Negara Malaysia • Exclusion-based method • Trimmed mean • Weighted median • Inverse variance • Core inflation at work • Lessons and observations

18. Mapping out dispersion in core inflation measures

19. Measures of core inflation are part of the overall inflation surveillance and forecasting framework Core Inflation forecast i. Price administered Goods ii. Govt measures i. Price Non- administered Goods ii. Econometric Model

20. Outline of Presentation • Why should monetary policy focus on core inflation? • Concepts of core inflation • Measures of core inflation at Bank Negara Malaysia • Exclusion-based method • Trimmed mean • Weighted median • Inverse variance • Core inflation at work • Lessons and observations

21. Lessons and observations • Despite its prevalence, there is neither a commonly accepted theoretical definition nor an agreed method of measuring core inflation. • No single measure performs well across the board, but a compromise conclusion on the usefulness of measures of core inflation is that each one may provide a different insight into the inflation process. • There can be value in looking at a range of measures, as long as one bears in mind what information each type of indicator is best at providing.