Saturday, January 31, 2015

The CPI isn't just made up in an office somewhere

So, the Bureau of Statistics has spoken. This week we learnt that prices rose by a mere 0.2 per cent in the three months to December, reducing the annual rate of inflation to just 1.7 per cent. But how does the bureau come up with such figures? And who believes them?

Short answer: not everyone. The public knows so little about how the consumer price index is calculated, and the bureau's figures seem so much lower than the impressions of rising prices people gain from their own experience, that many people suspect the figures are just cooked up by bureaucrats in an office somewhere.

In reality, the structure of the CPI has been carefully thought through and a lot of effort and shoe-leather goes into ensuring the figures we are given each quarter are as reliable as possible. It's a trickier business than you might imagine.

For a start, there are lots of different ways to measure inflation. The bureau publishes maybe half a dozen different measures, of which the CPI is just one. You can measure the change in prices paid by businesses ("producer prices") or those paid by consumers, or a combination of both.

Even so, the CPI is by far the most widely used measure. As explained by the bureau on its website, it measures changes in the price of a fixed basket of goods and services bought by consumers in the households of the nation's eight capital cities.

Each quarter the bureau checks the prices of about 100,000 items. Prices are collected by visiting supermarkets, restaurants, department stores, schools and websites. These physical visits, in all states and territories, are supplemented by prices collected by telephone or the internet.

The aim is to collect the prices people are actually paying, so when items are on special or being discounted, the lower price is counted.

The 100,000 separate prices are grouped into 87 broad expenditure classes. These are then categorised into 33 sub-groups and 11 main groups: food and beverages; alcohol and tobacco; clothing and footwear; housing (rents, new house prices, repairs and maintenance, council rates, water, electricity and gas); furnishings, household equipment and services; health (including private health insurance); transport (motoring and fares); communication (telecommunication equipment and services, postal); recreation and culture (including audio-visual and computing equipment and services; newspapers and books; holiday travel and accommodation; sports, toys, hobbies and pets); education (public and private preschool, primary, secondary and tertiary); and insurance and financial services.

About every six years the bureau does a large survey, asking people to record exactly what they're buying and how much of their income they're spending in each category. It then adjusts the items included in the CPI basket of goods and services to ensure they are up to date.

More significantly, it uses this "household expenditure survey" to give each of the items in the basket the right "weight", or relative importance. You can't just throw in one loaf of bread, one new refrigerator and one new car. Bread is cheap but we buy several loaves a week, while refrigerators and cars are expensive, but we buy a new one only occasionally.

The bureau has been revising the content of the CPI basket and the weights given to the various spending categories every few years since 1948, as our habits and the economy have changed. Over such a long period, the relative importance of spending categories has changed a lot.

Then, and on average, food accounted for 31 per cent of household budgets, whereas today it's less than 17 per cent. Similarly, clothing and footwear has dropped from 22 per cent to 4 per cent. And household supplies and equipment have gone from more than 13 per cent to 9 per cent. Alcohol and tobacco have gone from almost 11 per cent to 7 per cent.

But if all these things are taking a smaller proportion of the household budget, it's only partly because they have become relatively cheaper. It's mainly because we are spending on things now that didn't exist 67 years ago, or choose now to devote a higher proportion of our hugely higher real incomes to some things but not others.

The classic example of the latter effect is housing: its share of household budgets has almost doubled to more than 22 per cent. And with most households now owning at least one car, spending on transport has almost doubled to 12 per cent of budgets.

Then there are the spending categories that have pretty much popped up out of nowhere: recreation and culture, 13 per cent; health, more than 5 per cent; insurance and financial services, 4 per cent; and education and communications, 3 per cent each.

One point to add: though the Reserve Bank's inflation target - to hold the inflation rate between 2 and 3 per cent on average over the cycle - refers to inflation as measured by the CPI, in practice it pays most attention to the average of various measures of "underlying" inflation, derived from the CPI.

This is because the "headline" CPI is quite volatile. It tends to bounce around because of the ups and downs in such things as petrol prices and the prices of fresh fruit and vegetables (caused by the weather), but also because of the one-off effect of government policy changes, such as the abolition of the carbon tax.

The Reserve Bank is interested in assessing the strength of general inflationary pressure in the economy and doesn't want to be distracted by temporary price changes that have extraneous causes. So it uses various statistical techniques to remove this volatility.

Its measures of underlying inflation showed that prices rose by 0.7 per cent in the December quarter and by about 2.3 per cent in 2014. Taken by itself, this gives the Reserve no reason to change the official interest rate on Tuesday.