Introducing a Systematic Measure of Idiosyncratic Prices
There is a risk that Bank of Canada staff may inadvertently be biased when analyzing inflation: when inflation surprises on the downside, staff might emphasize negative idiosyncratic factors. When inflation surprises on the upside, staff might emphasize the positive idiosyncratic factors. The goal of this paper is to create a systematic measure of idiosyncratic prices (SMIP) that would provide an unbiased evaluation of temporary factors in Canadian consumer price index (CPI) inflation. SMIP considers CPI components idiosyncratic when they have the highest scores based on five criteria: high volatility, low persistence, low degree of correlation with common movement across CPI components, low correlation with the output gap and extreme movements in the current period. The components captured by SMIP are found to account for a large proportion of the deviation of inflation from target over the sample, after controlling for the output gap. In the third quarter of 2018, in terms of the components and their contribution to the deviation of inflation from target, results from SMIP reinforce the narrative in the October 2018 Monetary Policy Report—CPI inflation is currently above target due to temporary factors.