RDP 9810: The Distribution and Measurement of Inflation 5. Conclusion

An understanding of the distribution of price changes is useful in establishing how the inflation process operates, and the implications for the measurement of inflation. This paper found that consumer price changes are widely dispersed and not normally distributed; the distribution typically has a longer right-hand than left-hand tail (it is positively skewed) and always has fat tails (leptokurtosis).

The extreme price changes in the tails of the distribution are usually considered to be unrepresentative of the persistent component of inflation caused by the interaction of aggregate demand and supply. These extreme price changes have a disproportionate impact on the mean rate of inflation, so that the mean is not always a good indicator of persistent inflation. Consequently, measures of core inflation which abstract from unrepresentative price changes are useful to policy-makers.

This paper examined the value of trimmed means for measuring core inflation, and concluded that they are useful for this purpose. There are significant gains from trimming even a small proportion of the tails of the distribution. The benefits typically rise as the size of the trim increases. The great majority of the improvements from trimming have been obtained once half of each tail is removed, that is, a 50 per cent trim. In almost all of the trials conducted, the advantages of trimming continue up to the 100 per cent trim. The 100 per cent trim may, therefore, be considered the best trimmed mean measure of inflation.

It was also found that because the distribution of CPI component price changes is systematically positively skewed, trimmed means should be centred on a percentile higher than the 50th. This ensures that they record the same average rate of inflation as the entire sample. In fact, the larger the size of the trim, the higher the percentile on which the trimmed mean must be centred. These findings highlight that an understanding of the distribution of price changes in the CPI is valuable in deciding on a core inflation measure.