Constructing and evaluating core inflation measures from component-level inflation data

This paper undertakes a comprehensive examination of 10 measures of core inflation and evaluates which measure produces the best forecast of headline inflation out-of-sample. We use the Personal Consumption Expenditure Price Index as our measure of inflation. We use two sets of components (17 and 50) of the Personal Consumption Expenditure Price Index to construct these core inflation measures and evaluate these measures at the three time horizons (6, 12 and 24 months) most relevant for monetary policy decisions. The best measure of core inflation for both sets of components and over all time horizons uses weights based on the first principal component of the disaggregated (component-level) prices. Interestingly, the results vary by the number of components used; when more components are used the weights based on the persistence of each component is statistically equivalent to the weights generated by the first principal component. However, those forecasts using the persistence of 50 components are statistically worse than those generated using the first principal component of 17 components. The statistical superiority of the principal component method is due to the fact that it extracts (in the first principal component) the common source of variation in the component level prices that accurately describes trend inflation over the next 6–24 months.

Title	Constructing and evaluating core inflation measures from component-level inflation data
Creator	Gamber, E. N.
Creator	Smith, Julie K.
Publisher	Journal of Forecasting
Academic Department	Economics
Division	Social Sciences
Organization	Lafayette College
Date Issued	December 2019
Date Available	2021-12-01
Type	Article
Language	English
Bibliographic Citation	Gamber, E. N. and J. K. Smith (2019 Dec) "Constructing and evaluating core inflation measures from component-level inflation data." Journal of Forecasting 38 (8): 833-852.
Standard Identifier	DOI 10.1002/for.2595
Standard Identifier	Handle 10385/gb19f720p
Permalink	http://hdl.handle.net/10385/gb19f720p
Rights Statement	In Copyright
Rights Holders	John Wiley & Sons, Ltd.