Statement on Monetary Policy – August 2024Box C: Headline and Underlying Inflation

This Box discusses the differences between headline and underlying measures of inflation and how the RBA uses them to guide monetary policy decisions. Headline inflation measures changes in the prices of goods and services that are bought by households, and is the measure that the RBA targets to be between 2 and 3 per cent. The Reserve Bank Board sets monetary policy such that inflation is expected to return to the midpoint of the target range. Assessing whether inflation will sustainably be at the midpoint may require looking through temporary volatility in prices. Measures of underlying inflation, which remove the effect of volatility in prices of some items, help to inform this assessment.

Headline and underlying inflation are forecast to follow different paths over the next couple of years (see Chapter 3: Outlook). Headline inflation is likely to be lower than underlying inflation in the near term, largely due to the Australian Government’s temporary measures to reduce the cost of living, and then increase as these measures unwind. The RBA closely monitors both headline inflation and underlying measures of inflation as they inform the outlook in different ways.

Headline inflation reflects the change in prices of items consumed by households and is the target for monetary policy.

The headline rate of consumer price inflation reflects changes in the prices of a representative basket of goods and services that households buy, as measured by the consumer price index (CPI). The CPI includes prices for thousands of items, including groceries, rents, transport and household appliances.

The RBA’s flexible inflation target is for the headline rate of inflation to be between 2 and 3 per cent.[1] The Reserve Bank Board sets monetary policy such that inflation is expected to return to the midpoint of the target range in an appropriate period of time, and remain there on an ongoing basis. In doing so, it considers the conditions needed for inflation to be sustainably at the midpoint of the target range. This includes, where necessary, looking through temporary volatility that does not reflect the underlying pace of inflation in the economy.

Paying attention to underlying measures makes sense because headline inflation can be affected by large swings in the prices of individual items that are unrelated to broader conditions in the economy. Such swings can occur for several reasons, including a temporary shock to supply from a natural disaster or due to global events, or a change to a government policy that results in a large change in the price of a particular item. For example, Russia’s invasion of Ukraine in 2022 reduced global energy supplies, leading to spikes in energy prices.

Underlying inflation removes the effect of volatility in a subset of items.

The RBA monitors a range of measures of underlying inflation that remove the effect of short-term volatility in a subset of prices. For example, the Australian Bureau of Statistics (ABS) calculates a measure – CPI excluding volatile items – that excludes fruit, vegetables and fuel, as they frequently exhibit large price changes. The ABS also calculates measures that exclude large price changes in a given period, regardless of whether the item is typically volatile. Trimmed mean inflation, for example, is the average rate of inflation after ‘trimming’ away the items with the largest price changes (positive or negative).[2]

The RBA considers the outlook for underlying inflation when assessing current monetary policy settings.

The RBA – and many other central banks – monitors and forecasts underlying inflation measures (Graph C.1).[3] This allows the Reserve Bank Board to look through volatility in prices and the effect of one-off or temporary measures that do not influence the underlying degree of price pressures in the economy. Considering forecasts of underlying inflation allows the Board to set monetary policy to return inflation sustainably to target.

This is because measures of underlying inflation are more likely than headline inflation to reflect current inflationary pressures, as they generally provide a better indication of price changes across most goods and services. This means they are more likely to reflect the future course of inflation and are useful for forecasting headline inflation. Evidence shows that headline inflation tends to move towards the trimmed mean, while the reverse is not true.[4] To construct inflation forecasts, the RBA first forecasts trimmed mean inflation (informed by economic models), and then forecasts headline inflation by accounting for changes in specific prices that we can be relatively confident will occur in the future.[5]

Graph C.1
A one-panel line graph showing headline inflation and trimmed mean inflation outcomes and forecasts in year-ended terms. The graph shows that trimmed mean inflation is less volatile than headline inflation.

Over the next two years or so, the differences between the forecasts for underlying and headline inflation primarily reflect changes in government policies to provide cost-of-living relief to households. Year-ended headline inflation is forecast to be ¾ percentage point lower than trimmed mean inflation in the September quarter of 2024. Most of this difference can be attributed to the recent introduction of new state and federal energy rebates (Graph C.2). By contrast, the year-ended rate of headline inflation in 2025 is forecast to be almost 1 percentage point higher than trimmed mean inflation, reflecting both the legislated unwinding of the 2024 electricity rebate and an increase in the federal tobacco excise.[6] While these policy changes will affect the rate of headline inflation (and at the margin might affect inflation expectations), it is assessed that they will not materially affect underlying inflationary pressures.

Graph C.2
A one-panel graph with a line showing headline inflation outcomes and forecasts in year-ended terms, and stacked bars showing contributions to year-ended headline inflation from trimmed mean inflation, and other factors in excess of trimmed mean inflation, which include the 2023/24 electricity rebates, 2024/25 electricity rebates, fuel prices, tobacco prices and other historical components.

Endnotes

Treasurer and Reserve Bank Board (2023), Statement on the Conduct of Monetary Policy, 8 December. [1]

That is, after ranking each item in the basket by the size of price changes, it is calculated by the weighted mean of the middle 70 per cent of the distribution of price changes. For more information, see RBA (2024), ‘Inflation and its Measurement’, Explainer. [2]

For examples of global approaches, see Conway P (2024), ‘The Road Back to 2% Inflation’, Reserve Bank of New Zealand Speech, 19 June; Bank of Canada (2020), ‘Understanding Inflation’, Explainers; Ehrmann M, G Ferrucci, M Lenza and D O’Brien (2018), ‘Measures of Underlying Inflation for the Euro Area’, ECB Economic Bulletin, June. [3]

See Brischetto A and A Richards (2006), ‘The Performance of Trimmed Mean Measures of Underlying Inflation’, RBA Research Discussion Paper No 2006-10. This result has also been verified more recently: tests for Granger causality suggest that trimmed mean inflation predicts headline inflation, whereas headline inflation does not predict trimmed mean inflation. Forecasts of headline inflation based on the trimmed mean also have lower forecast errors relative to forecasts based on headline inflation. In addition, the gap between headline and trimmed mean has historically tended to revert towards its mean of zero. [4]

See Cassidy N, E Rankin, M Read and C Seibold (2019), ‘Explaining Low Inflation Using Models’, RBA Bulletin, June. [5]

These differences between headline and trimmed mean inflation are within historical ranges, and larger differences were apparent at the onset of the pandemic. [6]