The difference between Headline inflation and Underline inflation (1 Viewer)

[JordaneVG]

What's the difference between headline inflation and Underline inflation? and why does the Australian government prefer Headline inflation more, nowadays?

 

[gnrlies]

What's the difference between headline inflation and Underline inflation? and why does the Australian government prefer Headline inflation more, nowadays?

Ok there is a few dimensions to this question that I want to deal with.

Headline inflation and underlying inflation refer to different ways in which inflation can be measured. Now let me point something out: inflation is inflation. There is not two kinds of inflation, simply two kinds of measures. Kind of like Fahrenheit and Celsius. In this case, headline and underlying measures are attempting to characterise the same thing, but in a slightly different way.

Headline inflation is what you are probably mostly familiar with, and that is essentially the CPI - A bundle of goods and services that is typical of most consumers. Underlying inflation is different in the sense that it removes volatile items. For example if oil prices rise by 20% this would be removed because this change is not typical of the rest of the economy.

Underlying inflation is essentially a measure of long run inflation because it removes these items that fluctuate in the short run. It is perhaps more accurate because it is not susceptible to large shocks within the economy in the same way as headline inflation. Alternatively it could be argued that because it does not consider these items, it is not a true measure of inflation.

A good example of this in practice involves cyclone Larry of a few years ago. This cyclone wiped out Australia's banana plantations and subsequently raised the price of bananas. Now I don’t know about you, but if bananas suddenly become five times more expensive, I might start eating more apples so the impact isn't as severe as the CPI might suggest. But the CPI does not change for these things under headline measures of inflation. In this instance underlying inflation was a more useful measure.

To the second part of the question, I would like to address two things. Firstly the government doesn't "prefer" one over the other. Each has its own usefulness. Treasury and the RBA don’t "prefer" one over the other. They each just say a different thing to the other. It could be said that political convenience makes one measure more popular than the other (the one that shows inflation to be lower) but in reality neither of these measures is consistently lower than the other. For example during cyclone Larry underlying inflation was much lower than headline inflation, however just recently when oil prices dramatically fell; headline inflation was much lower than underlying inflation. So it cannot really be said that one is used for political purposes. Nonetheless, it seems that headline inflation appears to be the main indicator used by most Australian institutions. It is the most highly publicised and the ABS does tend to promote this measure. I wouldn't read too much into it though, because most analysis would use both underlying and headline measures. I suppose it is just that headline inflation makes for a good 'headline' (excuse the pun).

One more thing and this is probably the most interesting point I can make about the topic, and that is how central banks treat these different measures when dealing with inflation targeting. Now in Australia we use a headline measure in our inflation targeting framework. Some countries however do use the underlying measure. The result is essentially the same, because in Australia we use a headline measure with a target band (i.e. 2-3%). The target band captures any volatility that exists within the headline rate. Other countries use underlying measures with a point target (e.g. 2.5%). Subsequently any volatility is captured not in the band (as of course it is a point target) but rather in the measure itself.