A Policy-Sensible Core-Inflation Measure for the Euro Area

Although the concept of core inflation is apparently well defined and intuitively appealing, its practical usefulness has often been questioned on at least two accounts: first, existing core inflation measures are by and large exclusively based on statistical criteria and thus lack a firm theoretical justification; second, there appears to be no generally accepted and plausible criterion to assess the empirical performance of competing measures. Both criticisms are indeed justified. In this paper we propose an approach to build a benchmark measure of core inflation that aims to overcome those drawbacks. Our measure is based on a criterion that explicitly treats core inflation as a wholly artificial concept whose usefulness rests only on its role in defuse inflationary pressures that may be in the pipeline. Our measure is obtained by conveniently combining disaggregate information coming from price sub-indices, as is the case for the most popular core inflation measures. However, we depart from all other approaches by combining the information available in price sub-indices in such a way so as to provide the best guidance to a forward-looking monetary policy-maker. Accordingly, our measure of core inflation is based on the solution of a standard monetary policy optimisation problem. We illustrate our approach using a simple estimated model of the euro-area economy and appraise the performance of a few of the most popular core inflation measures in use. We find, generally speaking, that one cannot recommend that those measures be used to support monetary policy-making.(This abstract was borrowed from another version of this item.)