CPI is a proxy for inflation

One of my hobby horses – what is inflation?

Arthur Seldon defines inflation as ‘a fall in the value of money due to a persistent expansion in its quantity’. Ludwig von Mises wrote that ‘everyone knows’ that inflation is an increase in the quantity of money. Furthermore he wrote that ‘everyone knows’ that a general increase in prices is a consequence of inflation. Yet, inflation is often defined as a sustained increase in the general level of prices. This latter definition, however, is unsatisfactory.

The Australian is reporting that the CPI contains a flaw, with the following headline:

Inflation figures contain ‘massive flaw’ for potential homebuyers, says CBA

The story is:

The true challenges confronting young Australians seeking to buy their first home are masked by a “massive flaw” in inflation data, according to a new report from Commonwealth Bank’s economics team.

The note, authored by CBA senior economist Gareth Aird, finds potential homebuyers are neglected by official inflation numbers, given the figures ignore the recent dramatic surge in house prices.

As it stands, the core measure of cost-of-living pressures used by analysts is the Australian Bureau of Statistics-released consumer price index (CPI), which does not factor in increases in land values.

Mr Aird contends the exclusion of the single largest purchase an Australian will likely make serves as a “massive flaw” in using CPI as a proxy for cost of living pressures. However, he stopped short of arguing for changes in land values to be incorporated in CPI.

Now I am sympathetic to the argument that the Consumer Price Index contains flaws. This must be true almost by definition. But it isn’t clear to me that the CPI should include house prices. It also isn’t clear to me that CPI is a comprehensive measure of inflation – it is a proxy for inflation but in and of itself isn’t inflation. Changes in the CPI will be due to a combination of factors such as inflation, changes in relative prices, and measurement error.

A true measure of inflation would include things such as housing and other investments and the like, but that isn’t the role of the CPI. This conflating changes in CPI as being inflation does lead to problems, however, as people think inflation is subdued; but Australians are facing price pressures, and a declining standard of living – why did nobody ever warn of this happening?

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35 Responses to CPI is a proxy for inflation

  1. A H

    Yes Sinc, instead of keeping CPI within a range, central banks should keep M3 within a range.

  2. OldOzzie

    If I were to rent my NSW House out, the NSW Land Tax on that single dwelling would be $28,916.00 for 2017, i.e $556 per week that the Tenant is paying, and does not know, as they are on a Residential Lease, as against on a Commercial lease, where the Tenant is liable for all outgoings including all increases covering Land Tax, Rates, Water Rates etc- add $3,000 Council Rates, $1,000 Water rates and the Tenant is paying $633 per week in Government Taxes, excluding GST

    – I would say the increase in Land Tax over the last 3 years, adds significantly to the CPI.

  3. Anthony Park

    Stupid questions – can the actual amount of liquid cash in the economy actually be measured? Eg the median amount of cash per bank account year on year? Do banks actually publish such data?

  4. Sinclair Davidson

    Increases in Land Tax are a cost of doing business – but it’s not inflation nor a consumer price per se.

  5. I am Spartacus

    if it were only a consistent basket of goods.

    punters should also be mindful of the “magic” hedonic, substitution and other adjustments made to suppress the actual CPI number.

  6. Ripper

    We should rename inflation to what it really is.

    Invisible taxation

  7. entropy

    Buying a house is purchasing an asset. Should an asset be in the Consumer Price Index? If it was to be included then surely it should also be net of capital gains. What would that do to CPI?

    Come to think of it, dot was arguing the other day that in some cases a house purchase could be consumption. I am prepared to consider that, but couldn’t think of instances myself.

  8. Leo G

    Inflation figures contain ‘massive flaw’ for potential homebuyers, says CBA

    Is the CBA saying that the CPI should be a basket of all goods and services weighted by total volume cost price for each item type in the basket, and not just weighted by geography?
    It seems that the CBA want to incorporate the effect, of house prices and house rent on that part of income available for discretionary spending, on an index of representative, statistically-sampled prices.

  9. Ripper

    “A dwelling-house, as such, contributes nothing to the revenue of its inhabitant, If it is lett [sic] to a tenant for rent, as the house itself can produce nothing, the tenant must always pay the rent out of some other revenue.” Therefore Smith concluded that, although a house can make money for its owner if it is rented, “the revenue of the whole body of the people can never be in the smallest degree increased by it”.

    Adam Smith – The Wealth of Nations.

  10. Paul Farmer

    I am totally with Sinc on this. I read the article and was left thinking most of the argument is totally a straw man argument…………as Sinc succinctly says the CPI was never intended to be an all purpose price deflator for everything aspect of our society.

  11. A H

    The MSM media is somehow touching on the root of the whole scam. CPI is not inflation, CPI is Consumer Price Inflation and measures the relative price increase of a ‘basket of consumer goods’. CPI specifically excludes assets, not just real estate, but shares and any sort of asset.

    This is the point of Keynesianism, to prop up asset prices. That’s really the whole point of it.

    Look at the increase of money supply, http://www.tradingeconomics.com/australia/money-supply-m3 .

    Almost a 200000% increase since 1965. Doubling four times since the early 2000s.

    Where was this money supposed to go? If you somehow constrain the increase of CPI, a measurement that excludes assets, then the increase can only go into assets. People act like this is a big surprise that houses cost so much but it’s inherent in the whole central banking, fiat currency scheme.

    It is 100% the fault of government intervention that the money supply increases
    at all. Fractional reserve lending increases the money supply but this is only possible to operate indefinitely due to central banking.

    I do not know who this CBA guy is or why he decided to put this comment out there, but he pretty much hit the nail on the head.

  12. H B Bear

    People don’t need the ABS to tell them they are going backwards. What they do need is a political system, Parliamentary structure and functional Federation that allows them to do something about it.

  13. Anto

    @Paul Farmer: “the CPI was never intended to be an all purpose price deflator for everything aspect of our society.”

    Agreed, however what has it become, in the public, media and government minds? Not what an economist perceives it to be. In the layman’s mind, it is a “cost of living” measure. As such, it should include a measure of the majority’s number one cost of living: housing expenses. [In my opinion, it should also include taxes, less subsidies.]

    I don’t care whether you change the name from “CPI” to something else, however the main cost of living index needs to track peoples’ actual cost of living. To me, that also means rethinking hendonic adjustments. If they have a real impact, it will show up in the difference between prices and incomes. Anything else is just a flying guesstimate.

  14. Razor

    I thought that the CPI takes into account the cost of housing via an average rent figure. Paying rent is a cost of living not an investment. Rent does reflect the changes in the cost of housing.

  15. Ray

    Housing is actually taken into consideration in the calculation of the CPI. In fact 22% of the basket of consumption used to calculate the CPI includes housing. New house construction comprises 9%, rents 7%, utilities 3% and other costs 3% (e.g. maintenance and rates). The only component of housing excluded are land values because land is not consumed.

    It should be noted that the sales of existing housing stock is not counted as this does not affect overall household consumption. A transfer of assets from one household to another may increase the consumption of one but at the cost of the other. In other words, the sale of existing houses does not change the net consumption capacity of households overall.

    As a result, the CPI is probably the most comprehensive measure of inflation we have. It is not perfect and certainly not the only measure which could be adopted, in this regard, Sinc is correct to argue that it is a proxy for inflation but, all the same, it is a very good proxy.

  16. Ray

    I should add that it is a concern when professional economists employed by a big bank would so readily proffer an opinion on the CPI without first understanding that index. This is grossly unprofessional and another reason why the reputation of the economics profession is not particularly great.

    The problem is not economics, only poor economists, of which there are far too many.

  17. J-man

    The issue is not the definition of inflation, but the use of the cpi for inflation targeting by central banks. The rba is caught in a trap where it would like to reduce interest rates to boost demand (whether you believe that works or not is irrelevant because they do believe) but also want to raise rates to cool the housing market. A reduction in rates would see a small boost to the economy but also further increases to housing demand. An increase in rates will see housing demand reduce but also business investment.

    All of this talk about whether the cpi is flawed is irrelevant in the current situation. Even if land values were included in the cpi for inflation targeting purposes, the rba is still faced with the same dilemma. It is really a question for the future.

  18. Justin

    Not an economist but wouldn’t the CPI have land values embedded anyway? I mean the price of goods and services reflect the cost to produce and sell those goods and services and as rents are linked to the value of property wouldn’t you expect rising land prices to flow through into the other categories? Perhaps someone could explain this for me.

  19. Mundi

    Land isn’t consumed, so it’s an investment asset, and not a item of consumption. Rent is included in CPI, so is house costs (building only) and maintenance.

  20. tgs

    Saying CPI is flawed because it doesn’t include literally every possible item one could spend their money on is like saying the ASX200 is flawed because it doesn’t include literally every equity security one could purchase.

    It has a particular purpose. You can’t say that measure A intended for purpose A is flawed because it doesn’t achieve purpose B.

  21. The BigBlueCat

    Sinclair Davidson
    #2359616, posted on April 20, 2017 at 6:37 pm
    Increases in Land Tax are a cost of doing business – but it’s not inflation nor a consumer price per se.

    No, land tax is theft by government, simply because people have the audacity to hold property above an arbitrary value.

  22. James Gibson

    But it isn’t clear to me that the CPI should include house prices.

    Do you know what the CPI is designed to measure?

    If you arbitrarily exclude the most important consumer price, what you have is an utterly useless measure.

  23. Chris

    At one time I lived in Zombabwe, ruled by the Pres zombie. His motorcades regularly forced every car off the road so we could see seeming by the truck of soldiers with machineguns, the police cars, the black Benzes, more soldiers and machine guns and finally the withdrawal and zooming forward of the motocycle cops that cleared the roads.
    In that fair country lived the economist John Robertson who told us that most economists lived through their currencies halving or quartering in value, but he was privileged to live through equivalent experience to twenty other economists’ lives.
    This was before it went to hyper-inflation.
    I was asked by a young geologist why a zim dollar was not worth the same as a US dollar; after all, wasn’t a dollar a dollar? As a younger chump studying Econ 101 (in MBA), I started explaining about the relative demand for Forex and ZWD and the daily ups and downs of export and financial market clearances, but I had failed to ‘get’ the utterly basic thing he meant.
    After I thought about it, I would have responded that yes, I had heard that once the ZWD was more valuable than the USD. But someone found a way to reach into his pocket and steal some of the money he earned, and into the pocket of every person in Zimbabwe who had any Zim dollars and steal some of every Zim dollar in the country. That way was to just print and spend new money; when they spent their new dollar notes they stole the value from every note in the pockets of the people of Zimbabwe.
    That’s inflation.
    And when a vicious and dishonest political party in Australia creates a huge unfunded entitlement as a landmine for the succeeding Government, and succeeding government does not shoot the responsible politicians, confiscate their property and impoverish their children, they do the same to Australians.

  24. Squirrel

    If the adjustment of ABS salaries, and former politicians’ and Reserve Bank officials’ pensions, was linked to and capped at movements in the CPI, the reservations which many people have about the CPI would very likely diminish, if not entirely disappear.

  25. sdfc

    if it were only a consistent basket of goods.

    Expenditure changes over the years.

  26. JC

    It’s usually thought by most people that the Fed uses the CPI as it’s yardstick when determining guidance, but it doesn’t. The Fed uses the PCE, Personal Consumption Expenditures Index

  27. Tel

    https://fred.stlouisfed.org/series/PPIACO

    That chart is suspiciously flat during the Bernanke years… I’m pretty sure they were using it as a target at least around 2011 to early 2014 when it was bang on within a tight band, few percent either way.

    Since Yellen came along it has kind of wandered down and now its wandering up again… she has her own unfathomable style but we will see if it creeps back up and hovers near 200 again. It was pretty flat during the 80’s tracking closely at 100 which was when the Fed was serious about hairy chested inflation fighting and Volcker had his hand on the stick (what a guy!) That’s kind of the universal Fed reference point now.

  28. sdfc

    That chart is suspiciously flat during the Bernanke years

    I wonder why.
    https://fred.stlouisfed.org/series/PALLFNFINDEXQ

  29. Tel

    Value represents the benchmark prices which are representative of the global market. They are determined by the largest exporter of a given commodity. Prices are period averages in nominal U.S. dollars.

    Goof.

  30. Tel

    We’ve hit the complex stuff. When you measure the price of commodities in US dollars you often get a similar result to what you get measuring the price of commodities in US dollars. This is very deep, but what does it say about Fed policy? Precisely nothing.

  31. sdfc

    It’s not complex stuff at all Tel. Weak commodity price inflation was a global phenomenon.

    You’re the one who suggested it had something to do with Fed policy. The Fed targets the PCE price index not the PPI.

  32. sdfc

    By the way, the Fed’s biggest mistake was in misdiagnosing the nature of the weak inflation in the aftermath of the 2001 recession.

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