6 Sensitivity analysis

In this section, we analyse whether the estimates of the output gap presented in the previous section are robust to alternative measures of inflation, different assumptions on the priors used in the estimation, different steady-state assumptions and different periods of estimation.

6.1  Different measures of core inflation

In this section, we analyse whether the model output gap estimates are sensitive to different measures of inflation. The alternative measures of inflation we use are core inflation and non-tradable inflation. Like the Ben et.al paper, the core inflation rate used in this paper is the Consumer Price Index (CPI) excluding the food group, household energy and fuel. We also test the sensitivity of the results by using two different forms of the core inflation rate, namely, the year-on-year change and the annualised quarterly percentage change.

Figure 11 illustrates the three alternative measures of inflation compared to the trimmed mean inflation used in the baseline model. The annualised quarterly percentage change of core inflation is very volatile and the volatility is significantly reduced by expressing core inflation in the form of year-on-year change. Non-tradable inflation shows the largest inflationary pressures over the entire sample period.

Figure 12 displays the output gap estimates using various measures of inflation, showing that the four different estimates of the output gap exhibit a similar pattern and the differences are well within the 95% confidence band. The results suggest that the estimate of the output gap is robust to different measures of inflation, reflecting the fact that the new methodology does not depend entirely on one particular piece of information but takes account of all available economic information in estimating potential output.

Although both measures of core inflation result in a similar measure of the estimates of the output gap, the inflation dynamics from the model does match well that of the annualised quarterly percentage change of core inflation. The inflation pressures generated from the model is more persistent and less volatile than that from the actual data. It is unlikely that one can develop a model which could generate such volatility in inflation.

Figure 11 - Different measures of inflation

Figure 12 - Output gap estimates under different measures of inflation

6.2  Alternative assumptions on the priors

Owing to the ad hoc nature of setting the priors on the model's parameters, we assess the impact of the priors on potential output by doubling the size of the prior mean of the standard deviations of the shocks which drive the potential output process, namely, and . The following table presents the prior and posterior means of the standard deviations and their variances for the new and baseline specifications.

Table 6 - Different specifications on the priors

	New				Baseline
	Prior		Posterior		Prior		Posterior
	mode	dispersion	mode	dispersion	mode	dispersion	mode	dispersion
	0.080	0.063	0.149	0.009	0.040	0.032	0.084	0.004
	0.133	0.063	0.233	0.009	0.067	0.032	0.122	0.005

Figure 13 displays the output gap estimates obtained under our baseline and new specifications. The new estimates exhibit a similar pattern and are also within the 95% confidence band associated with the baseline estimate. However, the estimate of the new output gap is smaller than that of the baseline model, reflecting the fact that the new prior implies a more volatile potential growth rate. The result points to the importance of the size of the priors as they are key assumptions in determining the level of volatility of the measures of potential output. In other words, the model would generate a smoother potential output series (i.e., less volatile potential growth rate) if you reduce the size of the priors on and .

Figure 13 - Output gap estimates under different priors on and