Friday, July 29, 2011

Attention Reserve Bank: Inflation is not as bad as it looks

Take a deep breath.

Inflation is not, as one commentator opined this week, “a disaster”.

It seems to me to be a long way short of what would be needed to bring forward an interest rate hike Tuesday, as the ANZ is now predicting.

There’s no doubt the headline figures are high: 0.9 per cent for the quarter and 3.6 per cent for the year. The underlying measures the Bureau of Statistics calculates for the Reserve Bank are high too, each coming in at 0.9 per cent for the quarter, and a more acceptable 2.7 per cent for the year.

But there are good reasons not to place too much weight on any of these figures, and the Bureau knows it.

From next quarter the Bureau will publish a new improved consumer price index, removing one of the most erratic and troublesome components and shunting it off to an appendix.

The so-called “deposit and loan index” is a valiant attempt to measure what banks charge. The fourth-largest component of the CPI, accounting for 4 per cent of the Bureau’s ‘shopping basket’ it is made up of the fees the banks charge directly and also an estimate of the margins they whack on to their rates.

Because the estimate is a derived number based on all sorts of assumptions it bounces around wildly... at times it turns negative.

In its submission to last year’s review of the CPI the Reserve Bank complained that the index jumped 16 per cent over the year to September 2008, "partly reflecting a one-off correction of earlier errors" adding an extraordinary 0.75 percentage points to the official CPI, before sliding 15 per cent and subtracting 0.75 points.

From the September quarter the Bureau will banish the estimated component from the official CPI, leaving in only the fees and charges it can measure.

In the June quarter figure just released, the last for which this will happen, the old-style deposit and loan index was responsible for about one tenth the increase in the CPI. The Reserve Bank knows all about this; it has complained about it loudly. It’ll see right through it.

Higher fruit prices accounted for an astounding 39 per cent of the increase in the CPI. They won’t last. It’s easy to see that by looking at what happened to the price of vegetables. They shot up 16 per cent in the March quarter after the floods, and then slid back 10 per cent as crops regrew.

Fruit trees take longer to regrow than vegetables, but they do regrow. Not only will the upward pressure from higher fruit prices soon leave the CPI, it’ll soon be replaced by downward pressure as fruit prices return to earth.

You might think none of this should affect the Reserve Bank’s two underlying measures of inflation, the ones that came in at 0.9 per cent you might think. You would be wrong.

One of the measures, the 'trimmed mean' is calculated by arranging all of the price movements in order of size, lopping off the top 15 per cent (of big movers) and the bottom 15 per cent (of small movers or price declines) and then averaging the price changes that are left.

The other measure, the ‘weighted median' also arranges movements in order and cuts out everything other than the middle price change.

How could an enormous price change like that for fruit boost those underlying measures? Not directly. Fruit would be excluded because it was one of the biggest price changes. But if it had previously been included because it was one of the mid-ranking price moves, it will knock one of the other big movers back into the mid-range to take its place; it will push up the trimmed mean indirectly.

It is clear that has happened. A different measure - CPI ex volatiles and deposit & loan facilities - came in at just 0.5 per cent in the quarter and 2.4 per cent over the year.

It doesn’t look a disaster to me.

Published in today's Age

Related Posts

. The CPI is broken. Give us money and we'll fix it

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

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