The challenges of calculating the Consumer Price Index
Best to remember the CPI has limitations
Sometimes it’s worth reminding ourselves of the CPI’s limitations, whether we can do anything about them or not.
Troy Media – by Will Van’t Veld
According to Statistics Canada, changes might be coming to the way we measure inflation. The Consumer Price Index (CPI) has long been accused of being biased upward, and the government certainly has an incentive to correct the bias, but it isn’t the only inflation issue worth highlighting.
Canada calculates inflation by conducting two surveys: a family expenditure survey, and a price survey. The former is conducted every couple years and determines how households allocate their spending, effectively calculating expenditure weights, whereas the latter is conducted monthly and estimates the price of the goods. The CPI is then the weighted average of the prices relative to a base year.
Inflation overestimated
It has long been known that the CPI probably overestimates inflation. One criticism has been that the weights were determined too infrequently. As relative prices change, households alter what they purchase, but this creates bias in the CPI if the weights aren’t also updated (this is called substitution bias). New product bias is the other major source of bias. For instance, it takes a while for the iPad and other new devices to be fully reflected in the CPI.
The bias might inflate CPI by as much as 0.6 per cent, according to recent commentary written by Prof. Chris Ragan of McGill University for the CD Howe Institute. It might not sound like much, but its impact is cumulative over time, affecting both monetary policy and government expenditures.
According to Ragan, the problem the bias causes for the Bank of Canada (BoC) is that it can be volatile from year to year. That is to say, the BoC is charged with targeting a 2 per cent annual inflation rate, and achieving that target is more difficult if it becomes a moving target due to volatility in the measurement bias.
Numerous programs are tied to changes in the CPI, from Old Age Security (OAS) to tax revenues (as tax brackets are adjusted to reflect inflation). This means both government expenditures and revenues are affected every year if there’s a bias present in the CPI.
How any correction in the bias would, in the long run, impact government budgets might be questionable. There would surely be an initially benefit, but since the BoC has been consistent with a target is 2 per cent – regardless of whether or not the bias is present in the data – over time one might presume that the removal of the bias would only be temporary.
There are two other issues when it comes to how inflation is measured. The first is how we account for the CPI’s largest component – housing – and the second relates to the quality changes of the goods and services that the basket represents.
The CPI is supposed to track consumer goods and services, but housing represents both a consumption good and an investable asset.
In Canada, housing costs are included on a user-cost approach, so interest rates play an important role: the “cost” of housing declines when interest rates move down. In the United States, housing is included on a rental equivalency basis. In either case, surging housing prices are only indirectly accounted for in the inflation rate.
The question has been raised as to whether the central bank should incorporate actual housing prices more formally into its interest rate decisions to keep bubbles from forming, especially in light of what happened in the United States. In Canada it appears that policy makers prefer to use mortgage insurance regulation as a lever to influence housing prices, but this is a relatively new tactic.
CPI has limitations
The other issue is that the CPI measures the cost of living, but over time new technology has improved the quality of our lives. Households spend a far lower percentage of their income today on food than they did in the past (lowering the weight of food in our basket) and the quality of almost every electronic product purchased is superior. All of this is thanks to technological improvements and their impact on productivity.
Should any weight be given to the fact that what that future dollar can buy will likely be superior to what it could purchase today? Everyone has heard a grandparent talk with reverence about the Coke that cost a nickel ‘back in the day’, but at the same time black and white TV cost a small fortune then. Today, it’s been replaced by a flat screen TV of infinitely greater quality.
Sometimes it’s worth reminding ourselves of the CPI’s limitations, whether we can do anything about them or not.
Will Van’t Veld is an economist with ATB Financial.
About the Author (Author Profile)
Markham began his journalism career writing columns in the mid-1980s for Western People Magazine, then reported for a small Saskatchewan daily. He has spent most of his career in media and communications, likes to dabble in politics, was actively involved in economic development for many years, thinks that what goes on in the community is just as important as what happens provincially and nationally, and has a soft spot for small business (big business, not so much). Markham is a bit of a contrarian and usually has a unique take on the events of the day.
Subscribe
If you enjoyed this article, subscribe to receive more just like it.
