Thursday 27 January 2011 by FIIG Research Legacy

What is the Australian CPI?

The Australian Consumer Price Index (CPI) measures quarterly changes in the price of a 'basket' of goods and services which account for a high proportion of expenditure by the CPI population group-metropolitan households

This 'basket' covers a wide range of goods and services, arranged in the following eleven groups: (i) Food, (ii) Alcohol and tobacco, (iii) Clothing and footwear, (iv) Housing, (v) Household contents and services, (vi) Health, (vii) Transportation, (viii) Communication, (ix) Recreation, (x) Education, and (xi) Financial and insurance services. Changes in the weighting pattern of the basket have been made at approximately five-yearly intervals to take account of changes in household spending patterns. The CPI now comprises fifteen series of price indexes which have been linked to form a continuous series. The ABS have commented,

Further changes were made in the 14th series in order to better accommodate possible changes in expenditure patterns as a consequence of The New Tax System. For example, in the 13th series CPI, photographic equipment was included with Audio, visual and computing equipment in order to better allow for the growing use of digital photography (it is both complementary and competitive with other visual equipment). In the 14th series, the repair of appliances was included with purchase to reflect the substitution being made between repairing and purchasing new appliance

While an important consideration in analysing price movement in Australia is assessing Australia's performance relative to other countries, a simple comparison of All Groups (or headline) CPIs may prove inappropriate because of the different measurement approaches used by countries for certain products, particularly housing and financial and insurance services.

One example of the different approaches for CPI measurement is the subject of hedonic adjustment, which is where a change in the quality of goods is adjusted for, in terms of the CPI price indices. For example, if a standard personal computer, purchased in year one, has a memory capacity of “x”, and if, in year two, the standard personal computer now has a memory capacity of “2x”, and if both computers have the same price, then statisticians need to adjust for a such change in the quality of the standard computer. This has been a topic considered by the ABS, and has recently been introduced in the case of personal computers, although the technique is much more widely applied in other countries, as the below note indicates,

The ABS has long been aware of the need for improvement regarding price indexes for personal computers, and progress in this regard has been discussed in meetings of the ABS Economic Statistics User Group as well as other forums. When faced with measuring prices for products that undergo rapid quality change, international best practice is to develop hedonic price indexes, provided suitable source data are available. This approach is being advocated by international agencies such as the Organisation for Economic Cooperation and Development (OECD), the International Labour Organization (ILO) and the International Monetary Fund (IMF). National statistical agencies that have access to suitable data sources have adopted this approach as a standard solution to dealing with rapidly changing products. The ABS has been developing a hedonic index for some years but, prior to obtaining an ongoing reliable data source, has not been able to implement the index until now.

Also, if the investor has a largely different spending pattern, from the CPI, then the CPI may not provide an adequate benchmark for measuring expenses. However, it can be argued that the CPI is generally adequate as a benchmark for most investors, since the ABS has set out to make the CPI representative of general consumption, and the ABS is continually looking to improve the CPI measure. In particular, the variations of spending by individuals can generally be seen as a minor issue, since inflation is now becoming a global phenomenon; inflation is tending to change in the same way across more and more countries.

Such a correlation of inflation rates can be argued to exist, where increases in global trade are gradually aligning the general trends in inflation among previously disparate countries, even though differences exist in terms of how inflation is measured. Hence, even though one may have a different expenditure pattern to the Australian dollar CPI basket, the general trend in inflation is becoming more and more consistent between countries over time. This means that even though one may be misaligned with existing spending patterns in one advanced economy, it is unlikely that the trend in inflation in any one country will be very different to the trend in inflation within other advanced economies. It is the general trend in inflation that will impact all individuals, as opposed to the rate of inflation at any one time, so the globalisation of inflation tends to reduce the relative impact of individual differences from the ABS CPI consumption basket.

Inflation is increasingly being viewed as a global phenomenon, since the application of technology, especially communication technology, has enabled the greater global integration of production. For example, it can be argued that global wage claims in developed countries have been moderated by the threat of substitution to low wage countries, related to more global production techniques, and advances in communication technology.

Some have argued that hedonic adjustment effectively reduces the true rate of inflation, so that governments pay a lower amount on ILB securities, as well as social security related payments. However, the general idea is sound, as the technique tries to adjust for changes in the nature of consumption, especially the effect that technology has had on improving the quality of consumption products. Accordingly, each government needs to carefully weigh the possibility that non-hedonic models of CPI will misstate inflation over time, by failing to take quality into account.