Executive Summary

1         The primary objective of monetary policy in Singapore is to promote low inflation as a sound basis for sustained economic growth. Indeed, economic policies in most industrial countries over the past two decades have given prominence to reducing the rate of inflation. In fact, a number of central banks have in recent years introduced what can be called "inflation target regimes", with explicit quantitative inflation targets.

2         Although inflation targets have often been expressed in terms of the "headline" or consumer price index (CPI) inflation, most central banks are also guided by some measure of underlying or core inflation in their conduct of monetary policy. The rationale for a core measure of inflation stems from the fact that monetary policy affects inflation with long and variable lags and, hence, is not suited to targeting short-term fluctuations in inflation. In addition, monetary policy should not react to changes in the price level associated with supply shocks. The CPI basket also contains items subject to price controls or special taxes, the price movements of which do not reflect market forces. Core inflation measures are designed to reflect the underlying trend in prices caused by demand pressures on production capacity and changing expectations of inflation, and disregard temporary fluctuations in inflation arising from supply shocks.

3         However, distinguishing between temporary and underlying changes in the rate of inflation is easier in theory than in practice. Early attempts at constructing core measures of inflation involved statistically smoothing out price shocks from the CPI in an ad hoc fashion. Such attempts, however, have been criticised for being devoid of economic rationale. More recent endeavours include the volatility-adjusted, median and trimmed mean inflation measures, and the output-neutral inflation of Quah & Vahey (1995).

4         This paper estimates several such measures of core inflation for Singapore and compares them with the one underlying measure of inflation monitored by the MAS, viz. CPI inflation excluding changes in cost of private road transport and accommodation. The MAS underlying and volatility-adjusted inflation attempt to address the weakness of the overall CPI inflation by systematically excluding those components that are volatile or subject to controls and hence likely to cause distortion to the measurement of an economy's underlying inflation. The median and trimmed mean measures of inflation approach the same task by respectively taking the 50th percentile and trimming off extreme inflation rates, in order to limit the influence of excessively large and small price movements. The output-neutral inflation, on the other hand, is derived by decomposing overall CPI inflation via a bivariate vector-autoregressive model of CPI and real output.

5         A series of tests performed on the statistical properties of the various core inflation measures suggest that no single measure is superior to the others and that all provide useful information on the underlying inflation process. Thus, while the median and 30%-trimmed mean inflation measures relate more closely to the long-term trend of inflation, the MAS underlying and volatility-adjusted inflation measures provide better short-term forecasts of inflation. All four measures of core inflation are also less volatile than and cointegrated with overall CPI inflation. The output-neutral core inflation measure, on the other hand, displays a striking inverse relationship with changes in the exchange rate, which is the principal monetary policy tool in Singapore.

6         The five measures of core inflation estimated for Singapore in this paper would provide useful and complementary information on the underlying inflation process that will help to further illuminate on monetary and exchange rate policy.