Underlying Rate Of Inflation

Published Sep 8, 2024

Definition of Underlying Rate of Inflation

The underlying rate of inflation, also known as core inflation, measures the long-term trend in the price level of goods and services excluding the most volatile items such as food and energy prices. This concept aims to provide a clearer view of the inflation trend by removing short-term fluctuations that do not represent the overall pricing environment.

Example

Consider the consumer price index (CPI) data for a given year. If energy prices surge due to geopolitical tensions and food prices spike due to a poor harvest, these changes might suggest a high inflation rate. However, such increases are often transient and do not reflect the persistent trend of overall prices. By calculating the underlying rate of inflation, economists exclude these volatile components to capture a more stable and consistent measure of inflation.

For instance, if the CPI report shows a 3% increase in overall prices but energy and food alone contributed to 1.5% of this increase, the underlying rate of inflation might be calculated at 1.5%. This excludes the volatile swings in energy and food prices, offering a clearer perspective on inflation pressures without the noise of temporary shocks.

Why Underlying Rate of Inflation Matters

The underlying rate of inflation is crucial for several reasons:

• Policy Decision-Making: Central banks, such as the Federal Reserve in the USA or the European Central Bank, use the underlying rate of inflation as a critical metric for setting interest rates and other monetary policies. By focusing on this measure, they can avoid reacting to short-term price volatility, ensuring stable economic growth.
• Economic Planning: Businesses and investors rely on the underlying rate of inflation to make long-term decisions regarding pricing, wages, and investment. It provides a more reliable indicator of sustained inflation trends, helping in strategic planning and resource allocation.
• Comparative Analysis: The underlying rate facilitates more accurate comparisons between different periods or regions by filtering out temporary and volatile price changes. This allows for a better understanding of relative inflation rates and economic performance.

Frequently Asked Questions (FAQ)

How is the underlying rate of inflation calculated?

The underlying rate of inflation is calculated by taking the consumer price index (CPI) but excluding specific volatile items, notably food and energy prices. This exclusion is because these prices can be highly volatile due to factors like seasonal changes, weather events, or geopolitical issues. The resulting measure reflects price changes in the remaining basket of goods and services, which tend to be more stable and indicative of long-term inflation trends.

Why exclude food and energy prices in the calculation of the underlying rate of inflation?

Food and energy prices are excluded because they are subject to sudden and significant fluctuations. For example, energy prices can be affected by geopolitical disruptions, and food prices can vary dramatically due to weather conditions, pest outbreaks, or seasonal supply changes. These volatile components can obscure the true inflation trend that is more relevant for long-term economic planning and policy-making. By excluding these items, the underlying rate offers a clearer signal of persistent price pressures.

Can the underlying rate of inflation differ significantly from the overall inflation rate?

Yes, the underlying rate of inflation can be quite different from the overall inflation rate, especially during periods of volatile price changes in food and energy sectors. For instance, if there is a significant rise in oil prices due to geopolitical tensions, the overall inflation rate might spike, whereas the underlying rate, which excludes this volatility, could remain relatively stable. This difference helps policymakers and economists distinguish between temporary price shocks and longer-term inflationary trends.

What are the limitations of using the underlying rate of inflation?

While the underlying rate of inflation is useful for identifying long-term trends, it has some limitations:

1. Exclusion of Important Components: By excluding food and energy prices, the measure might overlook the impact that sustained changes in these sectors can have over the long term.
2. Not Reflective of all Consumers’ Experiences: For some households, especially lower-income ones, food and energy expenditures constitute a significant portion of their budget, meaning the underlying rate might not reflect their actual experience of inflation.
3. Complexity in Measurement: Determining which items to exclude and calculating the underlying rate can be complex, potentially leading to debates over what should or should not be included.

In conclusion, while the underlying rate of inflation provides a valuable tool for policymakers and economists to understand persistent inflation trends, it must be used alongside other measures to give a holistic view of the economic environment.