RDP 9810: The Distribution and Measurement of Inflation 1. Introduction

Like several other central banks, the Reserve Bank of Australia has an explicit inflation target; specifically, the Bank's objective is to maintain average inflation over the medium term of between two and three per cent. Given the notorious long and variable lags of monetary policy, the central bank must set policy so that the expected outcome of inflation is consistent with the target. To do so, the central bank needs to discriminate between movements in inflation that alter the trend path of inflation, and movements that are transitory.

Measured inflation is subject to many shocks that are unrepresentative of the general trend in inflation induced by the interaction of aggregate demand and supply. In any given quarter, components of the CPI may be subject to transitory price movements, due simply to volatility or sharp exchange rate movements that are likely to be reversed over the longer horizon. Alternatively, there may be infrequent changes in the prices of CPI components that are either wholly or largely the result of changes in government policy. In either case, such movements in prices are not indicative of the persistent component of inflation. Typically, central banks examine some measure of core inflation that seeks to abstract from these influences. In Australia, the so-called ‘Treasury underlying CPI’ has been the core inflation series with the greatest prominence, although it is by no means the only measure of core inflation (RBA 1994).

This paper undertakes a detailed examination of the behaviour and distribution of Australian CPI component price changes, and uses this information to construct a preferred trimmed mean measure of core inflation. Most often, it is found that a 100 per cent trimmed mean is the preferred measure of core inflation. The 100 per cent trimmed mean focuses on the price change of a single component in the distribution, abstracting from the influence of extreme components in the distribution of price changes.