Inflation this, inflation that…we’re sure you’ve seen this economic buzz-word thrown into conversations or on attention-grabbing news articles before. But what does it actually mean, and why are there so many ways to measure it? 

Bringing it back to basics, the most common measure of inflation is the Consumer Price Index (more commonly known as CPI). The CPI tracks the cost of a wide basket of goods and services that households purchase, and aims to reflect price changes consumers face. 

This basket of goods and services includes things like food, rent, fuel, clothes, healthcare, transport, plus more! In fact, there are 87 total expenditure categories the ABS tracks when calculating the quarterly CPI. 

In other words, CPI measures the overall ‘cost of living’ as it changes over time. And that’s why people also call this the ‘headline inflation’ measure. 

Here’s a simplified example. If it cost you $100 to do your weekly shopping last year, but this year it cost you $104 to buy the same items, then CPI (= inflation) has gone up by 4% and it means your money has less buying power. 

‍Got it, so what’s the other measure of inflation?

There are actually a few other ways to measure inflation outside of CPI, but today we’ll focus on ‘trimmed mean inflation’ which is the RBA’s favourite metric. 

You see, the issue with CPI is that it takes into account ALL 87 expenditure categories, but some of these categories can have super volatile prices. For example, the cost of fuel changes weekly, and the price of energy can spike based on so many factors (like government rebates). 

With traditional CPI, it’s a bit like trying to figure out the average temperature of the city, but also including extreme temperatures like heat waves and snow… that might not happen very often. 

So, as a more reliable measure of medium term inflation, the trimmed mean was introduced. This measure takes seasonally adjusted price changes of the 87 categories and ranks them by size, before trimming away the most extreme positive and negative price changes…Leaving just the middle 70% to be averaged out. 

Essentially, it removes outlier numbers that might skew the measure, and why it’s also known as an ‘underlying inflation’ measure. 

‍Do we really need both measures?

In short, yes. While CPI is a pretty good reflection of changes in everyday life and cost of living, it’s not the most reliable number for longer term decision making. 

And that’s exactly what the RBA is trying to do. Economic policies require a future outlook of Australia’s economy, which requires a stable measure of inflation that isn’t impacted by the noise of short term events. 

So now you know why, when the RBA makes the call on whether to cut, pause or hike up interest rates, they’re not just looking at one measure of inflation!