Monthly Statistical Bulletin Feature Articles

What is an Underlying Rate of Inflation?

An underlying (or fundamental) rate of inflation measures the inflationary pressures in the economy that are predominantly due to market forces, i.e. changes in prices that reflect only the supply and demand conditions in the economy.

Why Not Use the Consumer Price Index?

The Consumer Price Index (CPI) is probably the most commonly used statistic for the calculation of inflation.

However, the CPI really only measures the changes in the cost of purchases made by wage and salary households in capital cities (see the Feature Article on the CPI in the August 1996 edition of Monthly Economic and Social Indicators). The main reason for introducing the CPI was for use in the wage adjustment process.

Although the CPI is a reasonable indicator of inflation over the long-term, it is not a good measure of the short-term inflationary pressures that are acting on the economy. This is because a large number of the items in the CPI basket of goods and services are affected by highly volatile factors, seasonal factors or government policy decisions factors:

•  highly volatile price movements are caused by climatic conditions (e.g. droughts or floods) or actions such as 'price wars' or industrial disputes;
•  seasonality affects price movements where items become available only at the same time(s) each year or more purchases of some items are made at certain times each year; and
•  government policy decisions affect prices through revenue raising (e.g. increases in excise, dwelling rents or transport fares) or regulation (e.g. monetary policy that affects interest rates or changes to the health system that affect the cost of health services).

The movements in the prices of such affected items mask the underlying inflation rate.

Which Measure of Underlying Inflation?

There is no correct measure of underlying inflation. Any proposed method is open to criticism, but ultimately a measure has to be used that answers most of the criticisms and is relatively easy to compute.

Economists at the Treasury and the Reserve Bank of Australia (RBA) independently arrived at very similar underlying rates, which they both calculated from the CPI.

The Treasury rate was mutually agreed to be the best available guide and has been adopted as the standard.

Calculation of the Treasury Underlying Rate

Treasury's underlying rate is calculated by removing from the CPI those items whose prices are directly influenced by highly volatile, seasonal or policy factors. Table 1 outlines the items that are removed and the reason for their omission.

This amounts to the removal of items that account for about 49% of the CPI while maintaining a balance between excluding the appropriate items and still having an adequate coverage of items to be priced.

Estimates of the Treasury underlying rate have been calculated back to 1971 and were first published by the Australian Bureau of Statistics in 1994.

Table 1: Items Excluded from the CPI Basket of Goods and Services

What it All Means

The Treasury underlying measure and the CPI All Groups measure (also called the headline rate) show very similar trends over the longer term but will diverge in the short-term - both of which are to be expected.

Even though many items are excluded in calculating the underlying rate, it does not mean the underlying rate will always be less than the headline rate. The underlying rate does not understate inflation.

When the RBA states that, on average, the monetary policy target for inflation is ideally at or below 2%-3%, it is the underlying rate that is being referred to.

Monthly Economic and Social Indicators Table 2.2

Table 2.2 tabulates the CPI All Groups weighted average of the eight capital cities index and the Treasury underlying rate along with the annual percentage change (i.e. change from the same quarter of the previous year) in both indexes.

The annual percentage changes in both indexes are also presented in a graph.

The CPI and the Treasury underlying rate are quarterly series that are updated in the 4th week after the end of each quarter.

This feature was prepared by Stephen Barber.

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