Assessing underlying inflation

The goal of monetary policy is to keep total inflation close to the 2% target. But inflation can be volatile, and it takes time for changes to interest rates to filter through the economy. This is why, when setting policy, it is important to distinguish between temporary movements in inflation and lasting ones.

Underlying inflation is the lasting—or persistent—part of inflation.1 It reflects the economic fundamentals that influence inflation, such as sustained cost pressures in the economy and imbalances between supply and demand.

Underlying inflation is not a formula, nor can it be measured with precision. Rather, it is determined by assessing a collection of inflation indicators, including measures of core inflation and measures of the breadth of inflation, and by analyzing individual categories of the consumer price index (CPI).

Because interest rate changes work with a lag, assessing underlying inflation helps ensure that monetary policy responds to lasting factors affecting inflation instead of temporary movements in prices.

The assessment for underlying inflation

Core inflation is one of the indicators the Bank of Canada considers when assessing underlying inflation. Measures of core inflation aim to filter out short-term noise, typically by excluding volatile components or large price movements.

In recent months, measures of core inflation have generally been between 2½% and 3¼% (Chart 34). In September:

• CPI-trim rose to 3.1%
• CPI-median was flat at 3.2%
• CPIX rose to 2.8%
• CPIXFET was flat at 2.4%

While many of these measures increased earlier this year, the upward momentum seems to have faded, and three-month rates have come down.

Measures of the breadth of inflation help gauge how widespread price increases are across goods and services in the CPI basket. In September:

• The share of CPI components growing faster than 3% and the share growing below 1% suggest inflation of around 2% to 2½% (Chart 35).
• The distribution of price changes stayed slightly skewed to the upside, which signals elevated inflation for several CPI components.

On balance, measures of core inflation and the breadth of inflation point to underlying inflation in the vicinity of 2½%. This is below the 3% level suggested by the Bank’s preferred core measures alone, CPI-trim and CPI-median.

Why underlying inflation matters

Price swings caused by temporary factors such as an energy shock or a drought can have a significant impact on total inflation. Measures of core inflation are typically used to filter out these types of volatile price changes and capture the more stable, underlying trend. But sometimes the Bank’s preferred core measures can give misleading signals. This is when the assessment for underlying inflation becomes important. It considers a far broader range of indicators and therefore gives a clearer signal on whether changes to inflation will persist or be temporary.

When underlying inflation is assessed to be largely consistent with the signal coming from the preferred measures of core inflation, the Bank does not need to be explicit about underlying inflation.