Inflation is not rocket science, although you certainly wouldn’t know that from all the discussion in recent days. To understand inflation properly means looking at headline and underlying measures.
When measuring underlying inflation, many countries such as the USA opt for the simple approach of just excluding food and energy. The statistical inflation measures – – weighted median and trimmed mean – – are overstating underlying inflation, distorted by the impact of China on food and manufactured good prices.
What does it all mean? One could perhaps be excused for being convinced that a degree in aerodynamics is required rather than a mere ability to measure price changes. Clearly, inflation is not rocket science, but esoteric concepts liked the “trimmed mean” and “weighted median” are also certainly not the easiest of subjects to master.
When looking at inflation, it’s not just a matter of looking at underlying measures or the headline rate – – everything needs to be taken into account. That’s what the Reserve Bank does and that’s what the average punter needs to understand.
When the Reserve Bank assesses inflation it looks at seven measures. Each measure provides a different perspective. The important priority is to determine the underlining current of inflationary pressures. Is inflation picking up steam, or is it stable? Once the Reserve Bank is able to gauge the current trends, it then needs to take a view about whether the trends will continue. The interest rates establishment business by the policymakers of the day always needs to be forward looking.
Chief equities economist at CommSec, Craig James, reports that his organisation has found that the statistical measures of inflation are currently giving an upward bias to underlying inflation.
“The weighted median can be influenced by the structural increase in global food prices as well as policy-induced increases in housing costs such as rent,” he points out.
Across the world, many countries such as the USA just rely on simple “exclusion” methods when looking at underlying inflation, James says. In the USA, food and energy prices are excluded to arrive at a core measure of prices. In Australia, the best equivalent measure is the CPI.
Yes, we had no bananas
Australia’s Reserve Bank focuses on seven measures of inflation in its quarterly Statement of Monetary Policy. While the two statistical measures – – weighted median and trimmed mean – – are included, so is the common “exclusion” method which is made up of the Consumer Price Index (CPI) excluding volatile items such as fruit, vegetables and petrol.
The Reserve Bank also looks at the headline or published inflation measure because that measures the total basket of goods that consumers buy. There may be upward or downward spikes in prices, but at the end of the day the CPI measures the cost of living. The Reserve Bank also looks at tradeable goods – – prices of goods that can be determined on world markets – – as well as non-tradeables. Or the prices of goods that are largely determined here in Australia. The best example of that was the 2006 cyclone-induced spike in banana prices that caused the headline inflation rate to hit 4.0 per cent.
The policymakers have to work out the best way to measure underlying inflationary pressures. In the USA, the Federal Reserve focuses on the growth rate of the core personal consumption expenditure (PCE) deflator that excludes food and energy prices. Despite the lofty sounding name, it is just a measure of inflation that excludes volatile items.
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