Wednesday, April 25, 2012

Getting inflation wrong

Nine months ago Alan Kohler labelled the June quarter inflation figures "a disaster".

"The June quarter consumer price index is a disaster. It means the “cautious consumer” that Glenn Stevens was talking about on Tuesday and the high Australian dollar have not turned into lower inflation; the disinflation from the GFC is finished and Australia’s dreadful performance on productivity over the past decade is being brutally exposed. The RBA will now have to whack us all over the head with the blunt instrument known as interest rates."

He was wrong, but he wasn't alone.

Only a few voices looked inside the figures and saw something much less worrying than on the surface.

I was one of the first.

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

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..."

All sorts of people rubbished my reasoning, Christopher Joye among them:

"These claims are wrong for two reasons. First, as I have explained before, deposit and loan charges have almost no impact on the "weighted median" inflation measure (which is simply the 50th percentile inflation rate and not affected by outliers like the trimmed mean can be). Second, RBS's Kieran Davies and Felicity Emmett have shown that even if you exclude this variable from the trimmed mean (or "average" core inflation)--which is a questionable decision--underlying inflation over the last half year is still running above the top of the RBA's target 2-3% per annum band."

He was one of the kind ones.

Fortunately (for us all) Tim Colebatch picked up the scent, pointing to further problems with the CPI:

"The weightings given to items in the CPI are based on an old survey of household spending. But the Australian Bureau of Statistics changes them to reflect price rises and falls, assuming that we keep buying the same quantities of goods regardless of price changes. That defies reality, and over time, creates a bias that overstates the inflation rate, as the index increases the weight of items that rise in price, and decreases the weight of items with falling prices...

Take bananas and computers. When this series began in 2005, fruit and vegetables comprised 2.1 per cent of our spending, and computers 1.5 per cent. But fruit and vegetable prices have soared since cyclone Yasi, while computers now pack far more power than in 2005.

But the bureau assumes we still buy just as many bananas, even at $12 a kilo, and buy 2005-strength PCs very cheap. So the CPI is estimated on the basis that fruit and vegetables now comprise 3 per cent of our spending, and computers just 0.5 per cent. And that is wrong."

Bit by bit it became clear that both the official and underlying figures had indeed been overstated. It's now accepted wisdom.

Instead of raising rates the Reserve Bank cut them twice and is about to cut them a third time, then probably a forth.

All but a handful got inflation wrong.

Related Posts

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

. Where were we? What's wrong with the CPI

. Inflation is not what it was - that's official