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Last update: 01/03/2023
Price fluctuation is a normal economic occurrence. However, when prices rise sharply, a government must pinpoint the cause to decide measures for preserving sound financial health. That’s where underlying inflation comes in. Here we tell you all about it.
An armed conflict involving top oil-producing countries sent the price of crude oil soaring in the 1970s. As a result, fossil fuel-dependent industries, like transport and manufacturing, and other less dependent industries, like agriculture and textiles, saw costs skyrocket. Measuring the oil crisis's toll on the economy — and especially on industries indirectly affected by the war — became essential. The answer was an indicator called "underlying inflation".
Differences between underlying and regular inflation
We’ve already told you about inflation and the consumer price index (CPI), which measures price fluctuation. But underlying inflation, which is closely linked to inflation, can help us understand why prices change more clearly.
Underlying inflation is different from regular inflation in two ways:
- First, inflation is based on price shifts in a basket of products and services we consume (CPI). But underlying inflation is only based on the price of things like processed foods, clothing, restaurants and communications — not things like energy (electricity, petrol, gas, etc.) or unprocessed food (fruit, vegetables, etc.).
- Second, inflation measures long-term price behaviour. But underlying inflation can be measured each month or quarter, which gives a short- and mid-term outlook on prices.
Why do we use underlying inflation?
Armed conflict, supply shortage, natural disaster, logistics and other factors that can disrupt production or trade often cause energy and unprocessed food prices to spike. Because underlying inflation is not based on energy or unprocessed food prices, it shows governments how prices are changing outside of major or temporary situations — often abroad — so they can assess the effect of economic policy faster.
Because food and energy prices can make markets more volatile, underlying inflation proves a more stable indicator. It shows a lower rate of price fluctuation than traditional inflation does. For instance, if a spike in energy or unprocessed food prices takes inflation to 8.3% but underlying inflation remains at 2.5%, we can see the impact energy and unprocessed foods have on the economy.
