Core inflation:

The concept of core inflation is to purge the components of transitory and nonmonetary changes from the CPI basket. This is all the more desirable when distribution of price changes departs from normality, as is the case in Pakistan as well as in other countries.

What Does Core Inflation Mean?

A measure of inflation that excludes certain items that face volatile price movements. Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation. Core inflation is most often calculated by taking the Consumer Price Index (CPI) and excluding certain items from the index, usually energy and food products. Other methods of calculation include the outliers method, which removes the products that have had the largest price changes. Core inflation is thought to be an indicator of underlying long-term inflation

Why use core inflation?

THERE is a bit of split among the central banks of the rich world over whether it is better to focus policy choices on headline inflation or "core", that is, broad inflation stripped of volatile components like energy and food prices. It seems intuitively right to use headline inflation; after all, people spend money on petrol and bread just as they do on computers and tax preparation services. The use of the core measure may seem opportunistic to laypeoplelike playing games with the numbers to get the figures that justify preferred policy choices.

How Inflation is Measured in Pakistan

Typically, national statistical agencies like the Federal Bureau of Statistics (FBS),produce an array of different price indices, which aggregate prices over particular subsets of prices in the economy. Usually, this includes a consumer price index (CPI), a producer price index (PPI), a wholesale price index (WPI), or a GDP deflator. It is generally considered that the ultimate concern of the monetary policy is the welfare maximization of final consumers rather than producers, so it is most relevant for monetary policy to focus on the CPI and core inflation measures based on the CPI.
Prices Indices in Pakistan (with Common Base Year 2001-01) Features Number of cities covered Number of markets covered CPI SPI WPI

35

17

18

71
Number of items covered

53

18

374
Number of commodities covered

53

425

92
Number of commodity groups

106

10
Number of price quotations

106,216
Reporting frequency

11,236

1,550

Monthly

Weekly

Monthly

Number of income groups

Four

Four

Four

Some of the products in the CPI basket have temporary price shocks. Since these shocks can diverge from the overall trend of inflation and give a false measure of inflation, so a subset of CPI called core inflation is used, as an alternate, to reflect the extent of underlying long-term inflation. Core inflation is calculated by excluding products with volatile and controlled prices from the CPI basket. There are two methods employed by the Pakistans FBS to calculate core inflation i.e., Trimmed-Mean Inflation (TMI) and Non-Food & Non-Energy (NFNE) inflation. TMI is computed by three steps: i. First all the CPI items are arranged in ascending order according to Year-over-Year (YoY) changes in their prices in a given month; ii. 20% of the items showing extreme changes are excluded i.e., 10% of the items at the top of the list and 10 % at the bottom of the list; iii. The weighted mean of the price changes of the rest of the items is core inflation. NFNE inflation is calculated by excluding food group and energy items (kerosene oil, petrol, diesel, CNG, electricity and natural gas) from the CPI basket. Here is a chart depicting historical CPI-SPI-WPI trends in Pakistan:

The inflation rate as measured by the changes in Consumer Price Index (CPI) stood at 14.1 percent during (July-April) of the current fiscal year 2010-11, as against 11.5 percent in the comparable period of last year. The food inflation is estimated at 18.4 percent and non-food 10.4 percent, against 12.0 percent and 11.0 percent in the corresponding period of last year. The core inflation also decreased from 11.0 percent to 9.6 percent Items July-April July-April 2010-11 14.1

2009-10 A Consumer Price Index 11.5 (CPI) B Wholesale Price Index (WPI) C Sensitive Price Indicator (SPI) 12.4

11.3

23.3

18.2

Source

FBS

The core inflation excludes the impact of food and energy and truly reflects the component of inflation after three months consecutive decline. House Rent component (Accounting for 45.9 percent of Core inflation) of core inflation was persistently decelerating for last 23 months since April 2009 but reversed in March 2011 as it witnessed first upward movement. It decelerated from as high as 18.9 percent in April 2009 to 6.5 percent in February 2011. However, it inched up to 6.6 percent in March and 7 percent in April 2011. On the other hand non-HRI component of Core inflation (accounting for 54.1 percent weight in Core index) started inching up from its lowest level of 6.4 percent in October 2009 and entered into double digit in April 2010. It remained in the double digit for the last 12 months and accelerated to 11.7 percent in April 2011. Second round impact of food inflation is visible on this component when it has gone up by 2.6 percent .

Main culprits for this escalation were inordinate rise in prices of cleaning, laundry and personal appearances, and prices of apparel and textiles. As one can see from Fig above the non-HRI component of the core inflation is playing an even more important role in build-up of core inflation. NonHRI component increased by 11.9 percent in JulyApril 2010-11 as compared to 7.2 percent increase in HRI component of the core inflation. The situation was altogether different in 2009-10 when HRI component increased by 13.8 percent and non-HRI component increased by8.3 percent. The main contribution in 2009-10 was coming from HRI component while in the current fiscal year the contribution is coming primarily from nonHRI component.

Conclusion: The price changes in Pakistan, as in other countries, are widely dispersed and also not distributed normally with a positive skewness and high kurtosis. The extreme price changes in the tails of the distributions are considered to be unrepresentative of the underlying inflation trend. These extreme price changes distort the mean rate of inflation, making it a less efficient measure of generalized inflation. Hence, measures of core inflation, which systematically filter out unrepresentative price changes, are more useful to policy makers. The analysis reveals that core inflation measures derived from Limited Influence Estimator (LIE) perform better over the estimates based on the more traditional exclusion principle. Further research may be appropriate to determine more precisely the benefits of using different measures of core inflation in policy analysis. In particular, it may be useful to examine more closely the usefulness of alternative measures in inflation forecasting.