Wayne Swan is in the AFR this morning ($) claiming credit for the low inflation rate.
The inflation numbers on Wednesday were another reminder that our economic fundamentals are in very good shape, by either international or historical standards.
Both headline and underlying inflation printed at their lowest levels in 13 years, with the underlying rate of 2 per cent over the year at the bottom of the Reserve Bank of Australia’s target band.
It’s widely accepted that the federal budget’s call on the economy has an impact on inflation. For example, there’s widespread acceptance now that lax fiscal policy towards the end of the previous government was in part responsible for high inflation, leading to 10 rate rises on the trot.
One factor helping contain inflation at present – and hence recent interest rate cuts – is the government’s strict budget discipline.
Stop sniggering – last time I checked the accumulated deficits under Swan’s treasurership were over $150 billion, by contrast Peter Costello had accumulated surpluses of almost $100 billion.
Something else very important has happened to inflation – the underlying weights got changed and some definitions too. While many readers might give up at this point it is an important story to tell – largely because Malcolm Turnbull was trying to tell the story at the time. Unfortunately I haven’t been able to track down the original source but here is the gist from a Peter Martin piece in 2008.
Mr Turnbull had argued that the costs of housing and financial services should be excluded from the Bank’s calculations of inflation because higher interest rates would only push them up.
Without mentioning the Coalition Spokesman by name the [RBA] Governor [Glenn Stevens] said that some Australians had argued that monetary policy in fact “makes the problem worse by actually raising prices”.
So let’s have a look at what Stevens’ said about financial services (emphasis added).
Suppose, though, that we did take out some of the ‘special factors’ that people nominate. Let’s, for the sake of argument, remove from the CPI rents and petrol, as well as the calculation of deposits and loan facilities. If we do that, the rate of inflation of the remaining items over the year to December 2007 is 2.1 per cent. No problem, right? Well, not exactly.
He then goes on to talk about being consistent and banana prices and stuff. That speech was given on March 11 2008 and the most recent annual CPI inflation rate figure was 3.3 percent the December 2007 quarter. Now I don’t know the relative contributions of rents, petrol and deposit and loans facilities to the CPI figures in 2008 but I do know the weights they contributed. Rent was 5.2 percent, Fuel was 3.79 percent and Deposit and Loan Facilities 4.47 percent.
So keep an eye on that Deposit and Loan Facilities number.
Every few years the ABS update the weights in the CPI calculation. The last change occurred at the September 2011 quarter (16th series). The previous change had occurred at the September 2005 quarter (15th series). So what I did was graph the inflation rate from June 2000 through to June 2012. That period of time encapsulates the entire series 14, series 15 and now the beginning of series 16. The series 15 data are shown in red.
At the beginning of the series we have the GST spike then a period of calm, then a huge amount of volatility and now falling inflation. I’m sure there are a lot of things going on in there but there is also this:
Volatility in the index during the global financial crisis (GFC) prompted concerns from users about the behaviour of the index. Recent experience has shown that movements in the index are highly sensitive to the detailed level of data available from financial institutions. The behaviour of related indexes during periods of heightened financial market volatility prompted a broader international debate surrounding the measurement of FISIM [financial intermediation services indirectly measured].
The concerns voiced in the review primarily related to the indirect fees component
of the Deposit and loan facilities index. Some of the concerns raised by users were:
- the weight assigned to Deposit and loan facilities and the consequent impact of the index on the All groups CPI;
- the volatility of the Deposit and loan facilities index, and whether this volatility is representative of indirectly measured financial service prices;
- the correlation between changes in the official cash rate target and the Deposit and loan facilities index, and whether this correlation is representative of indirectly measured financial service prices;
- the Deposit and loan facilities index sampling methodology;
- the treatment of products with fixed interest rates;
- the lack of international comparability;
- a perceived lack of transparency due to difficulties experienced in replicating the Deposit and loan facilities index, and difficulties explaining movements in the index;
- the best way to calculate the reference rate;
- the quality/robustness of the underlying data;
- the complexity of the calculation method; and
- the impact of changes in wholesale funding costs on the Deposit and loan facilities index calculation.
So a very dodgy number was adding a lot of volatility to the inflation data – in particular “the correlation between changes in the official cash rate target and the Deposit and loan facilities index” was a concern. So every time the RBA raised rates it had the effect of raising measured CPI. More or less what Malcolm Turnbull had said at the time and everyone else pooh-poohed.
So what has happened to the weights? Financial and Insurance Services have declined from 9.31 percent to 5.08 percent overall. Deposit and loan facilities has declined from 4.47 percent to 0.76 percent and only direct costs are included with indirect costs excluded.
I don’t know if it is possible to retrofit the CPI for September 2005 through September 2011 using the series 16 weights but that could tell an very interesting story about the political surrounding recent economic history.
Update: Noodle emails to remind me that Turnbull was also arguing that the increase in interest rate spreads during the GFC were also adding to measured inflation via the Deposit and loan facilities figure.