Thursday, April 01, 2010

Wednesday column: So you think you trust the Consumer Price Index?

Do you know what you are trusting?

What will matter most for the outcome of the minimum wage case currently before Fair Work Australia?

What will matter most for the Reserve Bank's decision on interest rates due next Tuesday?

One of the least-reliable measures of inflation in the world.

That's not my assessment, it's that of the Reserve Bank - one of the primary users.

Other critics are more savage, particularly those concerned with the anachronistic approach of the Bureau of Statistics in stifling competing measures of inflation in order "to ensure the broader user community is not confused".

The ABS deserves credit for publishing on its website each of the submissions to its review of the Consumer Price Index. They do not make pleasant reading.

The Reserve Bank board meets monthly with "the objective of keeping consumer price inflation between 2 and 3 per cent on average over the cycle".

Yet Australia's consumer price index is published only quarterly, leaving the Bank flying somewhat blind every second and third meeting, a distinction it says it shares with none of its G-20 counterparts. Worse, as it delicately puts it... "in recent years there have been a couple of instances of quarterly readings that subsequently proved not to be representative of the general trend."

After the Bureau releases what turns out to be a misleading number (which inevitably it does from time to time) the Bank has to wait the best part of half a year get its bearings back, in which time it may have adjusted rates the wrong way, or have not adjusted them when it should have, as was arguably the case in early 2007 when a very low CPI number helped dissuade it from increasing rates as subsequently did substantially later in the year.

Even when the CPI is not misleading, it is old. Many of the prices are collected monthly but "not published until as much as three months later, and then only as part of a quarterly average".

And much of it is misleading. The fourth largest component of the CPI, known as the deposit and loan index, is an erratic atttempt to measure interest margins and financial charges. The Bank says that index jumped 16 per cent over the year to September 2008, "partly reflecting a one-off correction of earlier errors" adding around 0.75 percentage points to the official CPI, before sliding 15 per cent and subtracting 0.75 points. Bizarrely the method used to create the index at times produces "a negative price" and at other times creates what the Treasury calls a "feedback loop between monetary policy and the CPI whereby tighter monetary policy contributes to a higher CPI result and vice versa".

The Treasury and the Reserve Bank want the component removed unless it can be improved.

But negative price changes turn out to be widespread throughout the CPI.

Rob Bray was this year awarded the public service medal for his work on the Harmer Pensions Review. His submission to the review, written from his new position at the Australian National University says alleged negative price changes are sprinkled throughout the indxex in a way that makes it hard to work out what is real and what is not.

For instance in the past three decades the Bureau's measure of the price of "audio visual and computing equipment" has slid 86 per cent at at time when the total CPI has more than tripled.

Although the Bureau doesn't reveal the contribution of computers to the apparent slide Bray thinks it would be substantial. It is true that computers are cheaper, but they are also better. The Bureau estimates how much better, and effectively subtracts that from the actual price.

It makes sense to do it for traditional goods such as coffee. If a jar doubles in size but the price remains unchanged, the Bureau is justified in recording in halving its measure of the underlying price.

But it needn't make sense when dealing with computers, or cars or rental housing.

Two decades ago computers came with 640k of RAM. Now they come with 1 gigabite. On that measure their quality has improved 1562 times, but their usefulness has not. Modern computers need that extra memory. They don't work without it.

Bray writes, "a computer's quality is more usually judged by an individual in the context of what they can do with it - a price index which does not take this into account does not reflect the way in which the cost of living has changed."

The Bureau acknowledges the concern in a paper prepared for the inquiry but dresses it up as a problem of "common perceptions".

Bray says it is not only that the Bureau's measure fails to accord with perceptions, it is also that it fails to accord with reality - with the actual price of a standard computer.

It is the same with motor vehicles. The CPI says they cost less than they did 20 years ago. But most cars don't. Bray says a Ford Falcon costs 80 per cent more.

The CPI says Sydney rents climbed 3.6 per cent per year in the past decade. But Rental Bond Board says they climbed 5.2 per cent per year.

Some of the difference would be due to the two measuring different things, but much would be due to ABS discounting actual rent increases to account for what it sees as improvements in the quality of housing. But Bray points out much of the improvement is due to regulations. As with computers it is no longer easy to buy earlier models.

The CPI is inadequate as a measure of the cost of living, as is the new special Pensioner and Beneficiary index which suffers the same defects.

But the bigger problem is that ABS won't reveal how big the potential problem is. Tom Hayes, a former head of the Industry Department writes it's "a sad lapse that the ABS that does not maintain any data about the extent of the adjustments it makes to shelf prices for changes in the quality of products."

At best, this looks like a desire to protect the franchise. The Bureau writes it "has a responsibility to ensure the broad user community is not confused by the presence of alternative CPI measures".

In reality this attitude is probably doing far more harm to its franchise than would sharing openly what it does and knows. The Bureau's work is far too important to be left to the Bureau.

Published in today's SMH and Age

Reserve Bank of Australia Submission

Rob Bray Submission

Tom Hayes Submission

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. Does the Reserve Bank think the Consumer Price Index is a joke?

. The living cost index that won't index living costs

. Do you think the CPI is a joke?