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Understanding Trend Inflation Through the Lens of the Goods and Services Sectors

Yunjong Eo (), Luis Uzeda () and Benjamin Wong

Staff Working Papers from Bank of Canada

Abstract: Monetary policy is largely concerned with managing the part of inflation that is persistent (or permanent), a quantity often referred to as trend inflation. For example, a casual reading of any monetary policy report from the Federal Reserve Board will make it clear that, in addition to total (or headline) inflation, the Federal Reserve also focuses on underlying (or core) measures of inflation that exclude more volatile components such as food and energy prices. This strategy is based on the belief that fluctuations in components such as food and energy prices are ultimately temporary and, consequently, should be excluded from monetary policy considerations about the long-run path of inflation. Trend inflation is thus closely related to the concept of core inflation, since both measures provide a reading on inflation without the transient “noise” that is expected to fade in the short run. A more recent development is that goods and services—the two main sectors used to measure inflation—have been experiencing considerably different dynamics over the past three decades. Our goal in this paper is to understand how such contrasting behaviors at the sectoral level affect the aggregate level of trend inflation dynamics. To do so, we develop an empirical framework that accounts for historical changes in the volatility and comovement of trend inflation in the goods and services sectors for the US. Our main finding is that, while both sectors used to contribute to the overall variation in aggregate trend inflation, since the 1990s variations in trend inflation have been almost entirely dominated by the services sector. Two changes in sector-specific inflation dynamics drive our key result: (i) a large fall in the variance of trend inflation in the goods sector; and (ii) the disappearance of comovement between the two sectors. We document similar findings when extending our analysis to Australia and Canada, suggesting our results are not US-specific.

Keywords: Econometric and statistical methods; Inflation and prices; Monetary policy: transmission of (search for similar items in EconPapers)
JEL-codes: C32 E52 (search for similar items in EconPapers)
Pages: 77 pages
Date: 2020-11
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Working Paper: Understanding trend inflation through the lens of the goods and services sectors (2022) Downloads
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