Friday 19 May 2017 by Craig Swanger Opinion

Inflation to fall as tobacco butts out

Inflation is already depressed and mostly propped up by taxes on tobacco and beer.  Likewise, wage pressure is low and falling as employment demand remains sluggish. The RBA has said they expect inflation to return to their 2-3% target range, but not until 2019 – now they face yet another headwind in hitting this target 

cigarettes in an ashtray

As discussed in our note “CPI will not rise as most economists expect – Imported inflation is historyExternal link - opens in a new window”, inflation is relevant for investors because the RBA – and most other central banks – use inflation as a measure of whether an economy is growing faster than it safely can.  This means that to predict future interest rates, we must have a firm grasp on what is going on with inflation. In the last article, we looked at fundamental drivers such as wages growth and global inflation. However, in 2017 there is another, more technical impact, – a planned change in the basket of goods used to measure inflation.

The Australian Bureau of Statistics measures inflation by looking at the costs of a basket of goods that is supposed to represent the average household expenditure pattern in Australia. Currently, they set this basket every six years, with the next change due to take effect in the 4Q17 CPI measure.  When this basket changes, it can have an impact on inflation, depending on spending pattern movements over the six years.  For example, in the past six years, there has been a large increase in spending on computer equipment and telecommunications, such as mobile phones and home internet, and a large drop in tobacco consumption.  Spending on electricity has fallen and spending on health has risen, relative to the rest of the basket.  This means that when the basket is reset in 4Q17, the proportion of the basket represented by computers, telecommunications and health will rise; and that represented by tobacco and electricity will fall. 

The impact this has on CPI depends on whether prices for those items are rising faster or slower than the average CPI.  If an item is to have a larger share of the basket going forward and its price is rising faster than average CPI, this change will have an upward impact on CPI, and vice versa.

Now the new basket hasn’t been released yet.  However, we do have consumption spending figures from the GDP data, which come from the same surveys, so we can estimate the likely impact of the 4Q17 change. Our estimate is that the change will push CPI down 33%, from 1.50%pa using the old basket to 1.17%pa using the new basket.

The single largest impact is tobacco.  Household spending on tobacco is down by 50% over the past six years, with tobacco price inflation the highest contributor to overall CPI. So the impact of reducing its share of the CPI measurement basket by 50% is large (0.25% of the total 0.33% change). 

The next biggest change is due to the rapid rise in consumer spending for telecommunications and computer equipment.  As prices for these items have fallen sharply, any increase in their basket representation has a downward impact on CPI.  They are responsible together for a 0.05% change in the CPI, small compared to tobacco.  Other items such as health (small upward impact) and utilities and fuel (small downward impact) are very minor in comparison.

Conclusion

While arguably just a technical change in CPI, it does highlight the artificial overstatement of inflation caused by tobacco excises. As we have previously opined, tobacco excise inflation is not relevant to the economic measure the RBA should be using, as it doesn’t reflect demand.  It also highlights the argument where tobacco consumption has been falling so rapidly that not only is its inclusion inappropriate, but the weight given to it is also distorting the real picture of inflation in Australia. 

We argue that tobacco should be carved out, which would leave 2016 CPI at 0.97%pa.  Even if left in at the new weights, 2016 CPI would have been just 1.17%pa – very weak, and far below the RBA’s 2-3% target.

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