How the Consumer Price Index (CPI) could indicate false inflation?

August 10th, 2010

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The Consumer Price Index (CPI) is one of the price indices used by the RBA to calculate the inflation figures felt by ordinary Australians. In fact, some of our pensions, wages and other payments are indexed to match the CPI.

However, sometimes the CPI really doesn?t seem to reflect the actual increase in the cost of living. According to this article, price inflation is close to 3.1%, however experts say that the increase in the cost of living feels closer to 5-6%:

There’s a disconnect between the high frequency items, which people regard as driving their cost of living and the broader measure of inflation, which includes less frequent purchases

We potentially have a scenario whereby cost of living is actually higher that is reflected in the CPI. However, the RBA will attempt to ‘manage’ inflation at the CPI rate (see Why central bankers are obsessed with inflation not breaching a certain band?), which means that they may mismanage their response to inflation.

The RBA?s response does not immediately hurt everyday Australians as much as it could. Increasing rates by small increments to fight 3% price inflation is not as bad as the increments required to fight 6% price inflation, especially if you?re heavily in debt. So let?s reverse that idea ? what about if cost of living increase is less than the CPI indicates? Suppose cost of living is increasing at a rate of 3% and the CPI was running at 6%. The RBA is vigorously increasing interest rates, whilst inflation is well ?under control?.

And this scenario could happen. The CPI is prone to overstatement of single items. The most recent CPI values for the year to June are heavily weighed down by a nearly 20% drop in Computers/Audio and a 6% drop in men?s clothes (single female technophobes must be doing it tough). A 50% rise in the cost of cigarettes could easily tip the CPI into high territory, whilst the non-smokers of Australia enjoy a lower level of inflation. Therefore, the RBA has to use other statistical hacks like “trimmed mean” and “weighted median” to smooth away the effects of once-off, seasonal or volatile price changes to arrive at an ‘underlying’ price index.

Yet, statistical hacks, regardless of how sophisticated the math is underneath them, are still not good enough. As we quoted Ludwig Von Mises in How much can we trust the price indices (e.g. CPI)?,

The pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred. In periods of slow alterations in the relation between the supply of and the demand for money they do not convey any information at all. In periods of inflation and consequently of sharp price changes they provide a rough image of events which every individual experiences in his daily life. A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell. She has little use for computations disregarding changes both in quality and in the amount of goods which she is able or permitted to buy at the prices entering into the computation. If she ?measures? the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less ?scientific? and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.

At the root of the problem with any price indices is that, as Mises said,

All methods suggested for a measurement of the changes in the monetary unit?s purchasing power are more or less unwittingly founded on the illusory image of an eternal and immutable being who determines by the application of an immutable standard the quantity of satisfaction which a unit of money conveys to him.

Basically, price indices, regardless of the level of sophistication, are not as ‘scientific’ as it seems. Central banks, however, have no choice but to rely on them to target price inflation with their monetary policy.

So, how much is the increase in your cost of living reflected by the CPI figures? Vote below!

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