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TIPS: The Trend Inflation Projection System and Estimation Results

November 21, 2016
Koji Takahashi*

Abstract

In practice, trend inflation is often defined as a common factor extracted from observed inflation rates by removing cyclical effects from business cycles as well as other transitory distortions. Trend inflation can also be interpreted as the infinitely long-term inflation rate expected by private economic agents. If we assume that the central bank's inflation target policy is fully credible, trend inflation will converge to the target inflation rate in the long run. In the short run, however, trend inflation and the target rate can differ due to adaptive, or backward-looking, expectations and changes in the extent to which the inflation target is credible.

Based on these considerations, this paper proposes a simple new methodology for projecting trend inflation, labelled the Trend Inflation Projection System (TIPS), where trend inflation is expressed as the weighted average of two components: an adaptive component, where a common trend is extracted from several core inflation measures, and a forward-looking component, namely the target inflation rate. In addition, the weights are allowed to vary over time to capture changes in the degree to which economic agents believe in the inflation target.

The estimation results show that trend inflation in Japan increased dramatically in the first quarter of 2013, when the BOJ raised the target inflation rate, and has continued to rise gradually since then. However, since the second half of 2014, medium- to long-term inflation expectations have shifted downward, meaning that inflation expectations may be formed in a more adaptive manner than in the model. Furthermore, decomposition of the consumer price index (CPI, all items less fresh food) based on the estimated model indicates that although CPI inflation rose from the beginning of 2013 due to the increase in trend inflation, it has decreased again since the second half of 2014 due to transitory factors such as the decline in oil prices.

Keywords
Core Inflation; Trend Inflation; Inflation Target

JEL Classification
C53, E31, E37, E58

The author is grateful for comments from Tomohiro Tsuruga, Koji Nakamura, Toshitaka Sekine, Hibiki Ichiue, Shigenori Shiratsuka, Toshinao Yoshiba, Ichiro Muto, Yoshihiko Hogen, Mitsuru Katagiri, Narek Ohanyan, Lawrence Christiano, Rhys Mendes, Gregory Bauer, and Toyoichiro Shirota. The author is also grateful for support from Saki Inoue in terms of data handling. Any remaining errors are the sole responsibility of the author. The views expressed in this paper are those of the author and do not necessarily reflect the official views of the Bank of Japan.

  • Research and Statistics Department, Bank of Japan
    E-mail : kouji.takahashi-2@boj.or.jp

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