8. Practical Issues Surrounding the New Understanding of Price Stability

Alessandro Zanello, and Daniel Citrin
Published Date:
November 2008
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Christopher Faulkner-MacDonagh

This chapter examines the issues facing the Bank of Japan’s (BoJ’s) Policy Board in implementing a new post-deflationary framework for monetary policy. The chapter provides an overview of the new framework and the ramifications of the Policy Board’s “understanding of price stability” as a range of inflation (over the medium term) from zero to 2 percent. While lower than the benchmarks used at other central banks, this chapter shows that the range may be appropriate because inflation has indeed been more subdued in Japan than in most industrial countries. This said, inflation expectations could be better anchored in positive territory if BoJ communications emphasized that most Policy Board members assess price stability as ranges for CPI inflation with medians close to 1 percent. Finally, while the Policy Board’s range focuses on headline CPI inflation, other price indicators could also be useful in assessing—and communicating—incipient inflationary pressures.1 In particular, the traditional measure of core inflation performs well in describing the medium-term inflation outlook. However, there is also a broader class of price indices, derived to correct some of the shortcomings of core inflation, that also perform well.

The Bank of Japan’s new monetary policy regime

In early 2006, the BoJ shifted strategy from targeting banks’ excess reserves (quantitative easing) to targeting the overnight interest rate. Under quantitative easing (QE), the BoJ adopted a policy of exceptional pre-commitment: to keep in place ample liquidity until core CPI inflation turned firmly positive. After several months showing a consistent increase in core prices, the BoJ announced an exit from QE on March 9, 2006—indicating that the BoJ would gradually drain liquidity from the banking system, while keeping overnight interest rates effectively at zero.

This change in strategy has also involved adopting forward-looking operational guidelines. The new monetary framework strikes a balance between policy pre-commitment (adopted under QE) and flexibility. The key elements include:

  • disclosing an “understanding of price stability”—that is, a survey of the Policy Board members on the range of inflation over the medium term consistent with price stability—of 0-2 percent inflation in headline CPI;

  • analyzing the risks to price stability from two perspectives—(i) near-term (one- to two-year) forecast of economic activity and prices; and (ii) longer-term threats including those arising from low probability—but high cost—risks;

  • conducting monetary policy according to these two perspectives, and publishing the results of the analysis periodically—as a rule, the Board’s findings would appear in the Bank’s semi-annual report and include their forecasts of activity and prices.

The new framework offers greater elaboration on the forecast and principal risks as seen by the BoJ. In this manner, the public benefits from a structured discussion of the Bank’s views on conjunctural conditions and the policy outlook. While the “understanding of price stability” is not an inflation target, it does serve as a reference for the dual perspective analysis, allowing the BoJ to respond flexibly to events. In particular, the BoJ has learned the lesson of the “bubble” period: the economy can overheat—and overinvestment can build rapidly—while inflation remains low.

The BoJ describes price stability using the headline CPI, because of its advantages over other indices. The CPI is well-understood, timely, and covers items used by the public in forming price expectations. Other indices are either specific to a sector (such as wholesale or service price indices) or not timely (such as the GDP deflator, which is also subject to substantial revisions). Core inflation is not used because price stability is a medium- to long-term concept, when measures of core and headline inflation should agree. However, as the next sections suggest, core inflation and other more robust measures of inflation do help in communicating about the underlying trends affecting the price level.

Japanese inflation in the historical and international context

The inflation range in the “understanding” may appear low, but the BoJ has considered various biases and frictions in the Japanese context. Strictly speaking, price stability occurs at zero inflation, although statistical biases mean that in practice inflation must be positive. Central banks have also noted that deflation can be costly and have built in a small safety margin. Against this backdrop, the BoJ has explained that the current range reflects that:

  • the statistical bias of the CPI index is low, thanks to recent methodological improvements;

  • Japanese wages exhibit more downward flexibility than in other countries, because bi-annual bonus payments represent around 20 percent of compensation and are routinely adjusted by firms with due regard to business conditions.

More generally, the BoJ has assessed the need for a safety margin against five factors: (i) the degree of rigidity in nominal wages; (ii) the level of potential growth; (iii) the robustness of the financial system; (iv) the availability of fiscal policy; and (v) the effectiveness of the monetary policy transmission mechanism.

Furthermore, for much of the recent history, Japan’s inflation has been in the middle of the range of G7 countries’ experiences (Table 8.1). Japan has been somewhat unusual in that it has experienced periods of both substantially higher-than-average and lower-than-average inflation in the G7.

Table 8.1International Inflation Trends, 1960–2006 Average annual % change in CPI
Other G7a3.310.34.12.4
United Kingdom4.414.14.92.6
United States2.
Industrial Countriesbn.a.

Averaged using purchasing power parity (PPP) weights.

International Financial Statistics (IFS) definition. Not available prior to 1968.

Sources: Haver Analytics, World Economic Outlook (WEO) database; IMF staff estimates.

Averaged using purchasing power parity (PPP) weights.

International Financial Statistics (IFS) definition. Not available prior to 1968.

Sources: Haver Analytics, World Economic Outlook (WEO) database; IMF staff estimates.

During the 1960s—and for most of the 1970s—Japan’s inflation rate was significantly above the average due to a number of factors. Importantly, the economy was growing robustly, and prices were converging to levels in the other industrial countries. At the same time, labor unions were strong—representing 35 percent of workers—and negotiated indexed wage contracts, which fueled cost-push inflationary pressures.

Economic changes after the 1970s helped to spark a sharp disinflationary trend in Japan that was larger than in other industrial economies. Cautious monetary policy, a decline in unionization, greater trade openness, an appreciating currency, and lower oil prices reduced inflation from a high of 23¼ percent in 1974 to 0 percent in 1987. While most industrial countries saw a decline in inflation, Japan’s was the largest and fastest (Figure 8.1). Other countries, on average, saw a decline of only around 10 percentage points over same period.

Figure 8.1Trend to Lower Inflation over the Medium Term

* Austria, Belgium, Denmark, Germany, Luxembourg, Netherlands, and Switzerland.

Source: Haver Analytics, IFS and WEO, IFS definition for industrial countries.

In most other advanced economies, inflation declined gradually through a two-stage process that left inflation at a low, but positive, level. In the first round, medium-term inflation fell from above 10 percent in the late 1970s to an average near 4 percent in the late 1980s.2 A second round of disinflation started in the mid-1990s and brought inflation down to around 2 percent, where it has remained.

Japanese inflation has been lower than in other advanced economies since the early 1980s.3 A substantial difference (around 2¼ percentage points) emerged during 1983-94, even prior to Japan’s decade of deflation. This difference was smaller in comparison to a group of relatively “low” inflation countries (Austria, Belgium, Denmark, Germany, Luxembourg, Netherlands, and Switzerland), but a gap of around ¾ percentage point existed over this period.

Since the mid-1990s, inflation has converged across countries (excluding Japan) to near the levels of traditional ‘low” inflation countries. Over the 1990s, most of the gap (of around 1½ percentage points) between relatively “high” and relatively “low” inflation countries disappeared (Figure 8.2). This convergence has occurred despite differing economic structures: across both small and large countries and with countries that have high and low fiscal deficits. Even the level of product regulation does not appear to have affected inflation.4

Figure 8.2Fiscal Balance and Inflation, 1996–2006

Source: WEO.

Reflecting these developments, central banks came to a broadly similar view regarding the desirable rate of inflation. Most central banks surveyed in Mahadeva and Sterne (2002) and Roger and Stone (2005) have an inflation range above 1 percent and mainly in the range of 1–4 percent.5 Central banks appear willing to keep inflation low, but not “too low.” This caution is partly explained by Japan’s deflation experience, but other central banks have faced operational difficulties, and recent research has highlighted the dangers of letting inflation drift too close to zero percent (WEO, 1999).

The historical experience suggests that price stability in Japan would be consistent with inflation in the low end of the range of other industrial countries. It is difficult to speculate when inflation in Japan would converge to the rates of “low” inflation countries. Notwithstanding the strong growth picture, the pace may be gradual, if Japanese inflation expectations are colored by the recent deflationary period (Fukui, 2006),

Methods for identifying and communicating price pressures

Medium-term trends in the CPI thus play a central role as a part of the BoJ’s understanding of price stability. The CPI has a number of advantages over other indicators (such as the GDP deflator): it is available quickly and with high frequency, is not subject to frequent revision, is well-understood, and is immediately relevant to consumers.

However, the usefulness of the CPI may be limited by statistical issues that impart an upward bias to measured inflation. As a fixed weight index, the CPI uses expenditure shares that are updated infrequently (in Japan, every five years). This imparts an upward bias because it fails to account for the fact that consumers tend to substitute relatively less expensive items for expensive ones.6 For Japan, the BoJ has indicated that recent methodological changes have reduced the bias significantly, and some now estimate the bias at between 15–30 basis points (Nishimura, 2006). By comparison, the upward bias in the CPI in other countries remains more pronounced, at around ½–1 percentage points.

Moreover, it is useful to glean additional information regarding underlying price developments by examining various other indices. Because headline CPI is somewhat noisy and concentrated on just consumption goods, it is possible to miss unfolding price pressures in other sectors of the economy. Indeed, most central banks have found it useful to report on a variety of price indices, to reflect developments across the economy. Even inflation targeting central banks that target the overall CPI inflation rate also look to a range of indicators to help guide and communicate policy, such as:

  • Core indicators: trend inflation is derived by eliminating selected, volatile components of the CPI (such as fresh food or food and energy).

  • Multiple-price indicators: price trends can also be discerned from an examination of a broad range of indices, such as the GDP price deflator and producer prices, which may reflect price pressures in various sectors.

  • Robust indicators: recently, attempts have been made to measure underlying inflation through indices that are robust to economic changes or to excessive volatility.

Core indicators

Different core inflation measures track medium-term trends well. Core inflation manages to smooth out the data over most (but not all) of the transient spikes in the contemporaneous data (Figure 8.3). Indeed, the Japanese definition of core inflation, which excludes only fresh food, is marginally smoother than the traditional definition (CPI less food and energy). Importantly, they both indicate that at present medium-term (three-year centered moving average) inflation is trending up (Figure 8.4).

Figure 8.3Core Inflation Trends

Sources: Haver Analytics; OECD.

Figure 8.4Inflation Trends in the Business Sector

Source: Haver Analytics.

The ease of calculation has made core measures a standard part of inflation analysis, but they are not without disadvantages. Their chief advantage is their simplicity; they are easy to calculate, easy to understand, and widely used. This makes them useful for communication. However, this approach can prove problematic; first, core indices can exclude a large percentage of the overall index.7 Second, core CPI can still remain volatile. Finally, the composition of goods in the core CPI often does not have a theoretical justification.

Multiple-price indicators

Because inflation pressures may develop in a specific sector of the economy, it is also useful to examine indices other than the CPI. Since the CPI covers consumption goods, it may miss developments in the business or external sector. To help address this shortcoming, alternative indices such as the producer price index or GDP deflator can also shed light on current developments.

Business sector indicators do not appear to match overall price developments well, but even these confirm that the effects of deflation are waning. Japan has two price indices of the business sector (corporate goods price index, CGPI, and corporate service price index, CSPI) that measure prices paid and received by business for most goods and services.8 While inflation in the business sector moves somewhat in line with medium-term CPI changes, there are gaps that persist over time. Indeed, during the late 1990s and into the early 2000s, they seem to show greater deflation than the headline measure of CPI. More recently, however, both the CGPI and CSPI are also trending upward.

Similarly, GDP-based price indicators also follow trend inflation, albeit with more noise and a lag. To understand developments in the broader economy, it can be useful to look at the deflators for private consumption expenditure and total domestic demand (Figure 8.5).9 These GDP-based series show mild, ongoing deflation through 2005. However, this may be due to the broader range of goods included in the GDP indices (for example, investment goods in the total domestic demand deflator) and methodological differences. (The GDP data are chain-weighted; the CPI is fixed base.)

Figure 8.5Trends in GDP Deflators

Source: Haver Analytics.

However, price indices from the business sector or the national accounts are more complex than CPI-based measures, which detracts from their usefulness. GDP-based measures include a broader range of goods (for example, investment goods and government services), are subject to frequent revisions, and are available only with a long delay. All of these complications make their use difficult for policymakers, especially as real-time indicators. The business-sector price deflators can include the prices of intermediate goods, whose ultimate impact depends on how these goods are used in final production.

Robust price measurement

Besides the core and multiple price indicator approaches, other analytical indices can be informative about underlying trends.10 The first approach (the “trimmed mean” estimator) excludes those components of CPI that have the largest effect on the headline rate. This “trimmed mean” index assumes that large price changes reflect temporary shocks to the trend rate (Bryan and Cecchetti, 1994). The second approach constructs a Fisher chain-weighted index, which closely approximates an “ideal” measure from consumer demand theory (Fisher, 1922). Notably, both match trend inflation well (Figure 8.6).

Figure 8.6Alternate Measures of Core Inflation

Sources: Statistics Office; IMF staff estimates.

However, the complexity of these indices can present additional communication challenges. In particular, the novel approach to their construction and relatively new nature would pose communications difficulties. For example, some studies have shown that the best forecast of medium-term inflation (using the trimmed mean estimator) requires removing as much as 75 percent from the CPI. However, such trimming would likely lead to questions as to whether “too much” information is being discarded. Furthermore, these two estimators disagree about inflation developments since 2000, so even robust approaches can offer different views on trend inflation.

Evaluation of the three approaches

A number of criteria can help serve as a guide to selecting which indicator is the most useful in assessing and communicating about inflation. Roger (1998) and Wynne (1999) suggest that an ideal price index should be: timely well-understood and trusted by the public, seldom revised, have a low or negligible bias, reflect the forward-looking component of inflation expectations, and be theoretically-based.

By these criteria, core CPI ranks well. Core inflation lacks only a link to theory or an estimate of forward-looking price developments. However, the lack of such elements also means that the index is simple to understand. Furthermore, the estimated bias of core CPI is low, with a substitution bias of only around ¼ percent.11

Importantly, the core CPI approach also appears to be a superior communication tool, matched only by the trimmed mean (Table 8.2). The CGPI and CSPI may be nearly as useful as core indices; however, there can be substantial deviations between consumer and producer price inflation. Meanwhile, the private consumption expenditure (PCE) deflator (a GDP-based measure) and Fisher chain-weighted indices are more difficult for the public to understand. Furthermore, both indices are based on survey data and can be revised substantially over time. Only the trimmed mean estimate of inflation is available as readily as core CPI, but the estimated bias is marginally lower, and research has shown that it is not much better at forecasting future inflation than the core CPI. At the same time, it may be difficult for the central bank to explain and justify the trimming process. (For example, why certain items were excluded or why a trimming percentage was chosen.)

Table 8.2Assessing Trend Inflation Measures
Substitution biasc0.0-1.5-0.40.0

Detailed information on the private consumption deflators is unavailable.

Has been used extensively in public documents in Japan.

Percentage point difference from headline Fisher chain-weighted index (1995-present).

For CGPI/CSPI: geometric average of business services and final demand goods.

For GDP: difference between private consumption deflator and Fisher index.

Detailed information on the private consumption deflators is unavailable.

Has been used extensively in public documents in Japan.

Percentage point difference from headline Fisher chain-weighted index (1995-present).

For CGPI/CSPI: geometric average of business services and final demand goods.

For GDP: difference between private consumption deflator and Fisher index.

It is also important that any trend measures of underlying price movements also be a useful predictor of future inflation. Silver (2007) suggests that any useful measure of core inflation should be chosen according to a number of criteria, including an empirical assessment. Shiratsuka (2006) recommends a specific test of whether a price index can predict future inflation while also being representative of current inflation developments. Specifically, the regression takes the form of:

where πt are current and 12-month ahead headline CPI inflation, and πtcore is a candidate measure of core inflation. If β is statistically greater than zero, then πtcore serves as a useful forecast of future inflation. If β is statistically equal to one, then πtcore also accurately captures the effects of temporary deviations in current deviation.

According to this test, the Japanese core CPI performs better than most other measures of core inflation (Table 8.3). All of the price indices have estimates of β that are statistically greater than zero. However, the estimates on headline inflation, the corporate price indices, and the “western” measure of core inflation (CPI excluding food and energy) are low. Indeed, for the corporate price indices, the R-square (R2) is also low, suggesting that these price indices may not be that useful to understanding true price pressures. By contrast, the Japanese core inflation measure has an estimate for β that is almost exactly equal to one, and the R2 is also reasonably high.

Table 8.3Forecast Performance of Trend Inflation Measures

Coefficient estimates and goodness-of-fit results from 12-month ahead forecast:


πt+12: 12-month ahead CPI inflation
πt: Current headline CPI inflation
πttrend: Candidate measure for trend inflation (see below)

For reference only; refers to a simplified regression of 12-month ahead inflation on current inflation.

Candidate Measures of Trend Inflation
Ex. FreshEx. Food &10%Fisher

For reference only; refers to a simplified regression of 12-month ahead inflation on current inflation.

For reference only; refers to a simplified regression of 12-month ahead inflation on current inflation.

However, the more robust measures of core inflation also fare well. In particular, the trimmed mean estimator has a higher R2, and although the parameter estimate for β is lower than that for core CPI, the two are both statistically not different from one. Surprisingly, the chain-weighted price indices (the PCE deflator and Fisher headline and trimmed indices) also perform well, even though the indices are constructed in a very different manner than the CPI. Indeed, the R2 for the regression using trimmed Fisher index and the PCE deflator are both higher than that of the core. Meanwhile, the parameter estimate for β in the regression using the headline Fisher index is close to the estimate in the core CPI regression (although the standard errors are higher and R2 substantially lower).


This chapter summarizes the new framework for monetary policy and examines the impact of Japan’s inflation history on the new understanding of price stability. The new framework represents an important improvement in communication. While the BoJ has come in for criticism regarding the definition of price stability for being too low, Japan’s inflation has also been lower than in most industrial countries. This experience suggests a lower range may indeed be appropriate. This said, inflation expectations would be better anchored in positive territory if BoJ communications emphasized that most Policy Board members assess price stability as ranges for CPI inflation with medians close to 1 percent. This emphasis could shift attention away from the often criticized—and misunderstood—zero lower bound of the Board’s “understanding of price stability” and support the view that the BoJ would not view stable CPI inflation at about 1 percent as a policy concern, in and of itself.

Second, the chapter also reviews several approaches to examining price developments and concludes that core inflation works well in explaining trend inflation. The core and headline measures of CPI will agree over the medium term, which is the reference period for the BoJ’s understanding of price stability. Nevertheless, it can be useful to have a set of indicators to help explain the current conjuncture. In that regard, the core CPI is smooth and matches some estimates of trend inflation. It is also well-understood by the public, which is a useful feature in a price index that is used as part of a central bank’s communication strategy.

Appendix 8.1: robust measures of trend inflation

Fisher chain-weighted price index

A significant source of bias in the CPI arises from the use of expenditure weights that are updated only periodically. In Japan, the updating process occurs once every five years. Over time, these weights will become less representative of current expenditure patterns, introducing errors. For example, when the CPI basket was updated in August 2006, inflation (under the new basket) was around ½ percentage point lower during the first six months of 2006 than first reported (using the old basket based on the 2000 base year).

The chain-weighting procedure attempts to fix these shortcomings by using weights that are updated each period. The resulting index is linked together with its level in the previous period, so the index is constantly freshened with weights reflecting the most recent data.

While there are many chain-weighting approaches, the Fisher index turns out to have optimal statistical properties. The Fisher chain-weighted index is a geometric average of a Laspeyres (previous period weights) and Paasche (current period weights) indices. Diewert (1976) shows that the Fisher version of chain-weighting does a better job at representing a true “cost-of-living” index than either the Laspeyres or Paasche indices.

The Fisher CPI is constructed using monthly data starting in 1980. First, detailed CPI data (nearly 600 items) are matched to 41 expenditure categories in the monthly Family Income and Expenditure Survey for workers’ households (from the Nomura Research Institute). Then, the expenditure and price series are seasonally-adjusted using the X12 seasonal adjustment process, and a quantity series is calculated from the seasonally-adjusted price and expenditure data. Since the FIES expenditure data does not include a “fresh food” category, the “core” Fisher price index is calculated by excluding the two items: the one with the largest positive and the one with the most negative contribution to headline inflation, where the contribution to growth formula is taken from Whelan (2000). In general, the procedure typically results in excluding categories that account for around 5–10 percent of the overall index (similar to the core CPI).

Trimmed mean price index

Not only does the CPI suffer from statistical biases, it is typically noisy—making it difficult to determine in “real time” the underlying trend inflation rate. Not only are the month-to-month changes in the CPI large, but the changes in individual price components can also be significant. Bryan and Cecchetti (1999) report that the standard deviation of the individual components of inflation are nearly six times higher than the average inflation rate. Shirakawa also notes that the distribution of prices are non-normally distributed, with “fat tails” (i.e. large deviations of the mean are common).

This noisiness suggests that a weighted average is not the best measure of the mean of the distribution. Noisy, or high variance, data suggests that the probability distribution cannot be represented with an exponential probability density function (e.g. normal). Instead, the mean of these fat-tailed distributions may not be well-defined. In these cases, it is better to use an alternate estimator, such as the sample median.

To address these statistical problems, Bryan and Cecchetti (1999) recommend taking a special weighted average of the index that excludes extreme values. They also show that this statistical solution has useful economic and econometric properties. The trimmed mean is less noisy, allowing policymakers to overlook the monthly blips. It also provides a better forecast for inflation, typically even better than core inflation.12 For Japan, Bryan and Cecchetti find that the optimal trimming excludes 76 percent of the sample (the 38 percent with the largest positive and negative inflation rates).


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Since the understanding is defined over the medium to long term, both headline and core CPI refer to the same concept. Furthermore, in Japan, the basket of prices constituting core prices excludes only fresh food (vegetables, fruits, and fish, around 5 percent of the CPI). Elsewhere, core prices commonly exclude food and energy products (which can exclude between one-quarter and one-third of the overall CPI basket).

In this chapter, medium-term inflation is measured by taking the three-year centered moving average of the year-on-year changes. The latest data suggest that the average rate of medium-term inflation on this basis is 2 percent for all advanced economies—1½ percent for “low” inflation countries (Figure 8.1).

This point is also made in Bank of Japan (2006).

Results are from a regression of the average inflation rate for Organization for Economic Cooperation and Development (OECD) economies from 1996 to 2004 on the level of product market regulations (both economy-wide and in the non-manufacturing sector) in 2003. Descriptions of the data are available in Conway and others (2005).

The Reserve Bank of New Zealand had a target range of 0–2 percent until 1997, when it was extended to 0–3 percent, and then further lifted to 1–3 percent in 2002. The Swiss National Bank equates price stability as annual inflation of less than 2 percent. The European Central Bank aims to keep inflation below, but close to, 2 percent over the medium term. See Chapter 7 of this volume for further discussion of the international experience.

See Moulton (1997), who also provides a useful overview of other biases.

In Japan, fresh food compromises only 5 percent of the CPI, but in other countries many more items are excluded. For example, in the United States, the core CPI excludes just under 25 percent of the overall index.

The CGPI is comprised of the prices of goods traded among companies, including both domestically-traded goods (910 items, 74 percent of the index) and those that are exported (222 items, 14 percent of the index) and imported (293 items, 12 percent of the index). In a similar manner, the CSPI focuses on the prices of services traded among companies, although it excludes some services that are difficult to measure at a monthly frequency (such as imputed interest of financial services, wholesale, or retail trade) or services to individuals. It, too, includes domestic and imported services.

These indices more closely reflect domestic price developments than the GDP deflator, because the latter includes the effects of import prices, but with a negative sign. A large increase in the price of imported oil shows up as a drag on the GDP deflator, even though consumers and businesses are paying higher prices.

See Appendix 8.1 for details on the construction of both indices. The results shown here remove the top and bottom 10 percent of the index that is the most volatile.

Estimates in Shiratsuka (1999) suggest that the substitution bias (which is corrected by a chain-weighted formula) accounts for around one-half of the total bias (substitution plus others). This gives an upper bound to the overall bias of the CPI index of possibly around ½ percent.

Measured by the root mean squared forecast error of the regression of trimmed inflation on the 36-month moving average of CPI inflation.

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