Underlying Rate of Inflation

Background

The underlying rate of inflation provides a measure of inflation that excludes volatile components, such as mortgage interest payments, presenting a stable view of price changes within an economy. This rate aims to give a clearer perspective on the long-term trend of inflation without the short-term fluctuations influenced by interest rate changes.

Historical Context

In the United Kingdom, the distinction between the ‘underlying’ and ‘headline’ rates of inflation has been particularly significant due to the inclusion of mortgage interest payments in the Retail Price Index (RPI). This differentiation began to receive more attention in the late 20th century as economists sought more stable indicators of inflation for policy formulation.

Definitions and Concepts

The underlying rate of inflation is primarily used to analyze core inflation by excluding mortgage interest payments, resulting in what is known as the Retail Price Index excluding mortgage interest payments (*RPIX). This is in contrast to the ‘headline’ inflation rate described by simple RPI, which includes such payments.

Major Analytical Frameworks

Classical Economics

Classical economists view inflation as affecting the price level through monetary factors. However, disaggregating volatile elements such as mortgage interest can help in understanding real price changes more accurately.

Neoclassical Economics

Neoclassical frameworks focus on the importance of expectations and market equilibrium. The underlying rate of inflation provides clearer signals for long-term economic planning and policymaking.

Keynesian Economics

Keynesians consider the importance of differentiating between short-term and long-term inflation expectations. Analyzing the underlying rate allows policymakers to adjust for external shocks and focus on demand management policies without the noise from interest rate variability.

Marxian Economics

Marxian economists may interpret the underlying rate of inflation’s utility in maintaining sustained capitalist stability by stripping out volatile inflation components that affect the working and owning classes differently.

Institutional Economics

It underscores how institutional elements, like mortgage markets and interest rate policies, play a key role in inflation assessment. Viewing the underlying rate helps to appreciate these institutional distinctions.

Behavioral Economics

Behavioral economists emphasize how excluding volatile components (such as mortgage interest payments) in measuring the underlying rate of inflation reflect consumer sentiments more accurately by reducing perception biases.

Post-Keynesian Economics

This perspective might argue the underlying rate provides insights into the fundamental imbalance or stability in the economy by looking at core prices unaffected by monetary policy-induced interest rate changes.

Austrian Economics

Austrian economists focus on money supply’s role in inflation and may utilize the underlying rate as an improvement over general inflation measurements that get clouded by short-term monetary policy actions.

Development Economics

Including and excluding certain components in inflation measurement helps understand a developing economy’s structural factors better. Developing nations can apply lessons from these distinctions to measure economic progress more nuancedly.

Monetarism

The underlying rate aligns with monetarist views by offering a tool to gauge core money supply impact on price levels, focusing policy measures on non-transitory inflation components.

Comparative Analysis

Comparing the underlying rate against the headline rate in various countries highlights the UK’s unique inclusion of mortgage interest payments in RPI. Most other countries’ RPI do not include this element, making their headline rate similar to the UK’s underlying rate (RPIX). This comparative analysis illustrates differing national approaches to economic measurement and policy implication.

Case Studies

United Kingdom

Analyzing periods of economic stress or growth can demonstrate how the discrepancy between RPIX and RPI has influenced central bank decisions. For instance, during post-recession recoveries, stripping out mortgage interest provided better insights for sustaining steady economic growth.

Suggested Books for Further Studies

1. “Inflation: Theory and Evidence” by Robert J. Gordon
2. “The Inflationary Process in the United Kingdom” by R. Neild
3. “Is Inflation Ending? Are You Ready?” by A. Gary Shilling
4. “Understanding Inflation and the Implications for Monetary Policy” by David A. Copplestone

Related Terms with Definitions

• Headline Inflation: The total inflation rate as measured by the Consumer Price Index or Retail Price Index, inclusive of all components such as food, energy, and housing costs. In the UK, this includes mortgage interest payments.

• Core Inflation: A measure that excludes certain items that face volatile pricing, typically food and energy prices, to provide a clearer view of long-term inflationary trends. This is similar in nature to the underlying rate of inflation referred as RPIX in the UK.

• Retail Price Index (RPI): A measure of the average change in the prices of goods and services purchased by households in the UK, including mortgage interest payments.

• Mortgage Interest Payments: The component of housing cost