The influence of economic indicators - CPI

The series of articles aimed at explaining commonly used macroeconomic indicators continues. In the previous one, I explained what the gross domestic product (GDP) measures and what its shortcomings are. Now it's time for another commonly used macroeconomic indicator - the consumer price index (CPI).

The CPI is most often used as a measure of price inflation in a country, in a given currency. That is, the index should measure the dynamics of prices of the most frequently consumed goods and services. For this purpose, weights are determined for a set of goods that correspond to those most frequently consumed by households. So far so good, but what potential disadvantages does the use of this indicator as a measure of inflation lead to? In general, we can divide the disadvantages into two groups: those related to the accuracy of measuring the index and those related to its use for making political decisions.

Does the CPI underestimate or overestimate price inflation?

There is hardly an economist who would dispute the claim that at any given time, the CPI underestimates or overestimates price inflation for a given period of time. The question is rather, which of the two hypotheses is more common?

The methodology of calculating the CPI allows for the manifestation of both hypotheses. The products and services in the consumer basket, as well as their weights, change every year to reflect the current state of household preferences. But the economy is very dynamic and consumer preferences change every day. An important role in this process is played by the price. The price of a good/service is an important signal to consumers and it has a very large weight in the decision to buy or not to buy.

For example, imagine that a consumer likes pork and chicken equally. In the CPI, both types of meat appear with a weight that, on average, measures how much all consumers consume pork and chicken. Our hypothetical consumer wakes up one morning and realizes that the largest poultry farm in the country has burned down. This inevitably leads, all other things being equal, to an increase in the price of chicken due to the reduced supply. Such an event would cause our example consumer, but also many others like him, to consume more pork instead of chicken until prices stabilize. This underestimates price inflation measured by the CPI, because for the specific period the weight of chicken from the previous one will be used, and it is obviously smaller due to the changes that have occurred in the market.

On the other hand, many economists argue that price inflation in countries like the United States does not accurately reflect reality because the consumer basket does not include the market price of housing, but uses the price of rents as a proxy. The latter (see Chart 1) have been growing at a relatively constant rate over the past 30 years, while house prices were heavily ballooned at the beginning of the new millennium. Consequently, price inflation in the United States has been underestimated in the years before the Great Recession and overestimated in the years after the bursting of the housing bubble. This may not seem so important at first glance, but in fact it leads to serious consequences for all economic agents.

Political and economic consequences of the shortcomings of the CPI

The latest example of the CPI in the US has serious implications for policymaking. The rate of price inflation is used as an indicator of the basis on which monetary and fiscal policy measures are based. The Fed's key interest rate was significantly reduced after the bursting of the Internet bubble in 2000. If the CPI included US property prices in its calculation, the rate of price inflation would have been much higher and this would have been a prerequisite for raising interest rates earlier, significantly limiting the inflation of the property bubble.

As for fiscal policy, price inflation is often used to index various types of social payments, such as pensions. When at the end of last year the GERB government decided to raise pensions by 10% from April this year, the argument used by Simeon Dyankov was that this would compensate for the accumulated price inflation during his party’s mandate. What follows from such a justification is that the consumer basket of pensioners coincides with the average in the country, which is far from the case. Pensioners spend a significantly larger part of their income on food, medicines and medical services than the average Bulgarian. This suggests that if a policy of indexing social payments is pursued, a differentiated basket should be used for each group of beneficiaries.

The conclusion we can draw is that it is inaccurate to look at the average inflation in an economy – each individual consumes a unique set of goods and services and has a personal price inflation (the National Statistical Institute offers an inflation calculator service, with which everyone can calculate their personal inflation - link). In addition, the CPI is a useful tool in the hands of politicians, which can be used to change the country's monetary or fiscal policy, which will have a direct impact on our lives. Let's not forget that the calculation of the CPI is a monopolized service by the statistical institute of each country, which may be a prerequisite for intentional manipulation. Wouldn't a system where there is competition between the provision of this type of data work better?

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