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
CPI item |
Weight (%) in CPI basket
|
Reason for exclusion
|
Volatility
|
Seasonality
|
Policy
|
Meat & seafoods |
3.001
|
X
|
X
|
|
Fresh fruit & vegetables |
1.417
|
X
|
|
|
Clothing |
6.264
|
|
X
|
|
Govt owned dwelling rents |
0.382
|
|
|
X
|
Mortgage interest charges |
6.608
|
|
|
X
|
Local govt rates & charges |
2.190
|
|
X
|
X
|
Household fuel & light |
2.339
|
|
|
X
|
Postal & telephone services |
1.715
|
|
|
X
|
Consumer credit charges |
2.498
|
|
|
X
|
Automotive fuel |
4.698
|
X
|
|
X
|
Urban transport fares |
1.212
|
|
|
X
|
Tobacco & alcohol |
7.475
|
|
|
X
|
Health services |
3.961
|
|
|
X
|
Pharmaceuticals |
0.820
|
|
X
|
X
|
Holiday travel &
accommodation |
2.349
|
|
X
|
|
Education & childcare |
1.939
|
|
X
|
X
|
TOTAL EXCLUSIONS |
48.868
|
|
|
|
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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