In the absence of economic slack, supply shocks, idiosyncratic relative price shifts, or other disruptions, underlying inflation is the rate of inflation that would be expected to finally prevail. 2 Underlying inflation is a helpful monetary policy benchmark because it gives an idea of the rate of price change that would be expected under “normal” conditions in an economy where resource use is not placing upward or downward pressure on inflation. Furthermore, examining the evolution of underlying inflation indicators over time might reveal intriguing and potentially policy-relevant aspects of the inflation process.
Because underlying inflation is defined in terms of an economic state that is unlikely to be realized exactly, it cannot be observed directly; instead, it must be inferred from the behavior of actual inflation, either in a univariate context or with additional reference to the behavior of inflation’s other determinants. In this note, I explain and evaluate a number of empirical methodologies that can be used to estimate underlying inflation. I show the outcomes of each technique and explain some of the policy implications of these findings.
I define inflation as the annualized log difference of the price index for personal consumption expenditures (PCE) excluding food and energy, commonly known as “core” PCE inflation, in the following.
3 Two factors have influenced this concentration on core PCE inflation. The fact that the Federal Reserve’s longer-run inflation goal is specified in terms of the PCE price index (rather than, say, the CPI or the GDP price index) is reflected in the use of this metric as a starting point. Second, excluding food and energy costs from overall inflation models eliminates a source of difficult-to-model variability; this makes multivariate estimating approaches easier to adopt, and should also assist univariate models produce better estimates. 4
Univariate estimates of underlying inflation
Stock and Watson presented the following empirical characterisation of inflation dynamics in a 2007 paper:
where $$pi$$ represents actual inflation, $$pi$$ represents trend inflation, and $$varepsilon$$ and $$eta$$ represent zero-mean, serially uncorrelated innovation terms (shocks) with variances that can vary at any time (a property known as “stochastic volatility”).
In this context, trend inflation can fluctuate from one period to the next.
5 The value of the trend that we expect to prevail now and at all future dates is equal to $$pi t$$, which is also the value of real inflation that we expect to witness next period and in all future periods, at any given time $$t$$. (The expected future values of the $$varepsilon$$ shocks, which cause real inflation to depart from trend, are zero since they are assumed to be zero-mean and serially uncorrelated.)
As a result, the inflation trend derived from this specification can be used to estimate underlying inflation. However, we should be wary of the model’s assumption that actual inflation deviations from trend are serially uncorrelated, because some influences on inflation (such as an increase in economic slack caused by a recession) can readily last longer than a single period. Allowing actual inflation deviations from its trend to follow an autoregressive (AR) process, for example, is a straightforward way to solve this worry while still using a univariate approach:
In this case, inflation deviations from trend are supposed to follow a first-order AR process with a time-varying parameter $$rho t$$ (allowing for temporal fluctuation in $$rho$$ allows for change in the persistence of these deviations over time). This specification is roughly identical to: $$ pi t approx pi_ $$ under the assumption that trend inflation does not fluctuate too much from period to period (so that $$ pi t approx pi_ $$).
It is an AR(1) model with variables that change over time.
6 This model indicates a long-run mean for inflation equal to $$mu t / (1-phi t) $$ using parameter values for a particular date $$t$$. This long-run mean can be used to assess underlying inflation because it is the value to which we expect real inflation to converge in the future. 7
Lines 1 and 2 of Table 1 show underlying inflation estimates from the StockWatson and time-varying AR models; the table shows the average estimate implied by the model during the 19982007 timeframe, as well as point estimates for 2007:Q4 (the start of the 20072009 recession), 2013:Q4, and 2019:Q2 (the end of the estimation period).
8 In addition, in the rightmost column, the 70 percent credible sets for the 2019:Q2 values are displayed. Despite their differences in specifications, both models produce estimates that are very similar, with current values that are close to each other and to the average value for the decade preceding the 20072009 recession. 9
What is the distinction between underlying and headline inflation?
Inflationary Pressures Beneath the Surface While Australia’s inflation target is specified in terms of CPI inflation (sometimes known as “headline inflation”), indications of “underlying” inflation can be relevant. These indicators do not include items with significant price changes (either frequently or in a given quarter).
What factors contribute to underlying inflation?
Inflation is defined as a steady rise in the price level. Excess aggregate demand (AD) (excessive economic growth) or cost-push forces are the two main sources of inflation (supply-side factors).
Summary of the main causes of inflation
- Demand-pull inflation occurs when aggregate demand outpaces aggregate supply (growth too rapid)
- Cost-push inflation, for example, occurs when increasing oil prices lead to greater costs.
- Depreciation – increases the cost of imported goods while simultaneously increasing domestic demand.
- Rising wages boost employers’ costs and consumers’ disposable income, allowing them to spend more.
- Inflation expectations – A high level of inflation expectations encourages workers to demand salary increases and businesses to raise pricing.
What is an underlying inflation measure?
What are the goals of underlying inflation measures? In a nutshell, the ABS produces underlying inflation figures by eliminating the influence of irregular or transient price movements in the Consumer Price Index (CPI).
What are the three different types of inflation?
- Inflation is defined as the rate at which a currency’s value falls and, as a result, the overall level of prices for goods and services rises.
- Demand-Pull inflation, Cost-Push inflation, and Built-In inflation are three forms of inflation that are occasionally used to classify it.
- The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the two most widely used inflation indices (WPI).
- Depending on one’s perspective and rate of change, inflation can be perceived favourably or negatively.
- Those possessing tangible assets, such as real estate or stockpiled goods, may benefit from inflation because it increases the value of their holdings.
What is the difference between the two types of inflation?
Keynesian economics is defined by its emphasis on aggregate demand as the primary driver of economic development, despite the fact that its modern interpretation is still evolving. As a result, followers of this tradition advocate for government intervention through fiscal and monetary policy to achieve desired economic objectives, such as increased employment or reduced business cycle instability. Inflation, according to the Keynesian school, is caused by economic factors such as rising production costs or increased aggregate demand. They distinguish between two types of inflation: cost-push inflation and demand-pull inflation, in particular.
What is the economic base effect?
- The base effect refers to the impact that selecting a basis of comparison or reference has on the outcome of a data point comparison.
- When comparing data points, using a different reference or base might result in significant differences in ratio or percentage comparisons.
- The base effect can cause comparisons to be skewed and deceptive results, or it can be used to increase our understanding of data and the processes that generate it if it is properly understood and accounted for.
Who suffers from excessive inflation?
Inflation is defined as a steady increase in the price level. Inflation means that money loses its purchasing power and can buy fewer products than before.
- Inflation will assist people with huge debts, making it simpler to repay their debts as prices rise.
Losers from inflation
Savers. Historically, savers have lost money due to inflation. When prices rise, money loses its worth, and savings lose their true value. People who had saved their entire lives, for example, could have the value of their savings wiped out during periods of hyperinflation since their savings became effectively useless at higher prices.
Inflation and Savings
This graph depicts a US Dollar’s purchasing power. The worth of a dollar decreases during periods of increased inflation, such as 1945-46 and the mid-1970s. Between 1940 and 1982, the value of one dollar plummeted by 85 percent, from 700 to 100.
- If a saver can earn an interest rate higher than the rate of inflation, they will be protected against inflation. If, for example, inflation is 5% and banks offer a 7% interest rate, those who save in a bank will nevertheless see a real increase in the value of their funds.
If we have both high inflation and low interest rates, savers are far more likely to lose money. In the aftermath of the 2008 credit crisis, for example, inflation soared to 5% (owing to cost-push reasons), while interest rates were slashed to 0.5 percent. As a result, savers lost money at this time.
Workers with fixed-wage contracts are another group that could be harmed by inflation. Assume that workers’ wages are frozen and that inflation is 5%. It means their salaries will buy 5% less at the end of the year than they did at the beginning.
CPI inflation was higher than nominal wage increases from 2008 to 2014, resulting in a real wage drop.
Despite the fact that inflation was modest (by UK historical norms), many workers saw their real pay decline.
- Workers in non-unionized jobs may be particularly harmed by inflation since they have less negotiating leverage to seek higher nominal salaries to keep up with growing inflation.
- Those who are close to poverty will be harmed the most during this era of negative real wages. Higher-income people will be able to absorb a drop in real wages. Even a small increase in pricing might make purchasing products and services more challenging. Food banks were used more frequently in the UK from 2009 to 2017.
- Inflation in the UK was over 20% in the 1970s, yet salaries climbed to keep up with growing inflation, thus workers continued to see real wage increases. In fact, in the 1970s, growing salaries were a source of inflation.
Inflationary pressures may prompt the government or central bank to raise interest rates. A higher borrowing rate will result as a result of this. As a result, homeowners with variable mortgage rates may notice considerable increases in their monthly payments.
The UK underwent an economic boom in the late 1980s, with high growth but close to 10% inflation; as a result of the overheating economy, the government hiked interest rates. This resulted in a sharp increase in mortgage rates, which was generally unanticipated. Many homeowners were unable to afford increasing mortgage payments and hence defaulted on their obligations.
Indirectly, rising inflation in the 1980s increased mortgage payments, causing many people to lose their homes.
- Higher inflation, on the other hand, does not always imply higher interest rates. There was cost-push inflation following the 2008 recession, but the Bank of England did not raise interest rates (they felt inflation would be temporary). As a result, mortgage holders witnessed lower variable rates and lower mortgage payments as a percentage of income.
Inflation that is both high and fluctuating generates anxiety for consumers, banks, and businesses. There is a reluctance to invest, which could result in poorer economic growth and fewer job opportunities. As a result, increased inflation is linked to a decline in economic prospects over time.
If UK inflation is higher than that of our competitors, UK goods would become less competitive, and exporters will see a drop in demand and find it difficult to sell their products.
Winners from inflation
Inflationary pressures might make it easier to repay outstanding debt. Businesses will be able to raise consumer prices and utilize the additional cash to pay off debts.
- However, if a bank borrowed money from a bank at a variable mortgage rate. If inflation rises and the bank raises interest rates, the cost of debt repayments will climb.
Inflation can make it easier for the government to pay off its debt in real terms (public debt as a percent of GDP)
This is especially true if inflation exceeds expectations. Because markets predicted low inflation in the 1960s, the government was able to sell government bonds at cheap interest rates. Inflation was higher than projected in the 1970s and higher than the yield on a government bond. As a result, bondholders experienced a decrease in the real value of their bonds, while the government saw a reduction in the real value of its debt.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
The nominal value of government debt increased between 1945 and 1991, although inflation and economic growth caused the national debt to shrink as a percentage of GDP.
Those with savings may notice a quick drop in the real worth of their savings during a period of hyperinflation. Those who own actual assets, on the other hand, are usually safe. Land, factories, and machines, for example, will keep their value.
During instances of hyperinflation, demand for assets such as gold and silver often increases. Because gold cannot be printed, it cannot be subjected to the same inflationary forces as paper money.
However, it is important to remember that purchasing gold during a period of inflation does not ensure an increase in real value. This is due to the fact that the price of gold is susceptible to speculative pressures. The price of gold, for example, peaked in 1980 and then plummeted.
Holding gold, on the other hand, is a method to secure genuine wealth in a way that money cannot.
Bank profit margins tend to expand during periods of negative real interest rates. Lending rates are greater than saving rates, with base rates near zero and very low savings rates.
Anecdotal evidence
Germany’s inflation rate reached astronomical levels between 1922 and 1924, making it a good illustration of high inflation.
Middle-class workers who had put a lifetime’s earnings into their pension fund discovered that it was useless in 1924. One middle-class clerk cashed his retirement fund and used money to buy a cup of coffee after working for 40 years.
Fear, uncertainty, and bewilderment arose as a result of the hyperinflation. People reacted by attempting to purchase anything physical such as buttons or cloth that might carry more worth than money.
However, not everyone was affected in the same way. Farmers fared handsomely as food prices continued to increase. Due to inflation, which reduced the real worth of debt, businesses that had borrowed huge sums realized that their debts had practically vanished. These companies could take over companies that had gone out of business due to inflationary costs.
Inflation this high can cause enormous resentment since it appears to be an unfair means to allocate wealth from savers to borrowers.
In 2021, what is causing inflation?
As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.
Who is the most affected by inflation?
According to a new research released Monday by the Joint Economic Committee Republicans, American consumers are dealing with the highest inflation rate in more than three decades, and the rise in the price of basic products is disproportionately harming low-income people.
Higher inflation, which erodes individual purchasing power, is especially devastating to low- and middle-income Americans, according to the study. According to studies from the Federal Reserve Banks of Cleveland and New York, inflation affects impoverished people’s lifetime spending opportunities more than their wealthier counterparts, owing to rising gasoline prices.
“Inflation affects the quality of life for poor Americans, and rising gas prices raise the cost of living for poor Americans living in rural regions far more than for affluent Americans,” according to the JEC report.
What is the best inflation rate?
The Federal Reserve has not set a formal inflation target, but policymakers usually consider that a rate of roughly 2% or somewhat less is acceptable.
Participants in the Federal Open Market Committee (FOMC), which includes members of the Board of Governors and presidents of Federal Reserve Banks, make projections for how prices of goods and services purchased by individuals (known as personal consumption expenditures, or PCE) will change over time four times a year. The FOMC’s longer-run inflation projection is the rate of inflation that it considers is most consistent with long-term price stability. The FOMC can then use monetary policy to help keep inflation at a reasonable level, one that is neither too high nor too low. If inflation is too low, the economy may be at risk of deflation, which indicates that prices and possibly wages are declining on averagea phenomena linked with extremely weak economic conditions. If the economy declines, having at least a minor degree of inflation makes it less likely that the economy will suffer from severe deflation.
The longer-run PCE inflation predictions of FOMC panelists ranged from 1.5 percent to 2.0 percent as of June 22, 2011.