RDP 9810: The Distribution and Measurement of Inflation 4. Behaviour of the Statistical Core Inflation Series

Figure 7 demonstrates that the statistical measures of core inflation perform well in capturing the trend in quarterly rates of inflation. In most quarters, the core series record similar rates of inflation to the mean. Importantly, however, they differ when there are extreme price changes that have a large effect on the mean rate of inflation. In the early 1980s, the core CPI series did not reflect the enormous changes in medical costs. The mean CPI rose due to increases in prices of imported goods and health and optical services in late 1986 while the core series recorded more moderate price growth. Again in 1990/91, the core series had smoother paths than the mean inflation rate as they were not affected by the large petrol price shocks. While the statistical core inflation series abstract from extreme price changes, they do exhibit cyclical patterns consistent with demand conditions. The core rate of inflation declined in the early 1980s recession and then recorded a subsequent increase in price pressure. Over the remainder of the decade, the core inflation series recorded gradually easing price pressure culminating in the low, stable rates of the 1990s.

The manner in which the core series abstract from unrepresentative price shocks is clearly demonstrated in two episodes in the 1990s. In December 1992 and March 1993, and then again in the June and September quarters of 1995 the quarterly rate of inflation measured by the CPI jumped. However, on both these occasions there were large contributions from policy-induced price changes (cigarettes and tobacco, health and pharmaceuticals) and transitory movements of exchange-rate influenced or inherently volatile prices (cars, and fresh fruit and vegetables). By abstracting from these large volatile contributions, the core series provides a better indication of demand induced inflation.

As demonstrated in Figure 8, the core series behave similarly to the Treasury underlying rate of inflation, a series that has been widely used as a measure of core inflation. However, while the cyclical movements have been similar, over the later part of the sample, the core series often lie above the underlying inflation rate. The higher average rate of inflation recorded by the core series largely reflects the faster growth in the prices of policy-affected components, which are permanently excluded from the Treasury underlying CPI, over the 1990s. The higher inflation rate of the non-market components has resulted from an increased emphasis on user-pays principles of pricing. Like the underlying series, the core inflation rate captured the demand induced rise in inflation in 1995/96. Since then the core inflation series has not slowed as markedly as the underlying series. The appreciation of the $A and the subsequent fall in import prices contributed to the decline in the underlying rate of inflation. The core series largely abstracts from these currency induced extreme price movements, and so has recorded slightly higher inflation over the past year and a half.