The Inflation Dragon is on the hunt.
The annual CPI movement of 7.3% is the highest since 1990.
Central banks and governments face the Herculean task of bringing the worst inflation in decades under control. The Labor Party’s first budget was one of “hard decisions for hard times” and the Reserve Bank has been resolute in its commitment to rate rises, promising aggressive moves if inflation runs hot over summer.
There is no doubt that the fight against inflation has dominated our policy and fiscal decisions. It has forced many Australians – especially those on lower incomes – to embrace a brutal cost crunch in their budgeting. With the cost of transport, groceries, and housing all on the rise it is hard to deny that inflation exists. But how is it calculated and what is behind the ominous 7.3% inflation figure for the September quarter?
The Consumer Price Index.
The Australian Bureau of Statistics (ABS) uses the consumer price index (CPI) to measure price movements over time. The simplest way to think about the CPI is to imagine a fixed basket of goods and services that a hypothetical household buys every quarter. This household is supposed to be representative of the standard metropolitan household In Australia. As prices of the components of this basket change, the overall value increases. Any increase in the price for this basket is inflation.
What is in the basket?
The CPI basket is divided into 11 groups, including: food and non-alcoholic beverages, alcohol and tobacco, clothing and footwear, housing, furnishings, household equipment and services, health, transport, communication, recreation and culture, education, and insurance and financial services. These groups are then divided into 33 sub-groups, which each have 87 expenditure classes. These expenditure classes group together similar items, such as various types of motor vehicles. So it is quite an extensive collection of elements.
When calculating CPI, price movements in each category are scaled depending on that category’s total share of expenditure. These weights improve the accuracy of headline CPI data, as the quarterly price change reflects a household’s overall consumption. In doing so, we free ourselves from inaccurate data skewed by more or less volatile segments. The basket groups are re-weighted annually to reflect current consumption patterns.
Although the weights are expressed in terms of expenditure shares, it is not the expenditure shares that are held constant from period to period. Instead, the ABS holds the quantities of products underpinning each expenditure constant. So this might be the litres of petrol or loaves of bread a household purchases each period.
It is important to note that the CPI only measures price changes and not the price level.
The index launches off a base year, which is two years behind the current year. Prices for this base year are set at 100.0 points, with any change to prices moving the index away from this value. For example, a 5.5% increase in prices would cause the index to shift to 105.5. So if bread had an index of 92.6 and cereal had an index of 101.1 it would not mean that cereal is more expensive than bread. Rather, it would tell us that cereals have risen in price while breads have fallen.
How does the ABS collect prices?
ABS staff make personal visits to different retail outlets, check prices in online stores or marketplaces, and utilises transaction or scanner data. It is increasingly using web scrapers to collect online prices which allow it to record prices more frequently. This is an exhaustive process; the CPI is based on over 900,000 price quotations each quarter. ABS price quotations take into account government subsidies (such as Medicare or child care benefits), discounts, and tiered prices offered to different groups. The aim is to capture a more realistic snapshot of people’s spending.
Let’s bring the conversation back to today’s data.
Headlined as an “inflation dragon” and a “scourge” which threatens our way of life, it is easy to fall into the hysteria of infinite price rises. But it is much more complicated than that. The dramatic cost push seen in the CPI are not evenly distributed and there is more to ‘cost of living’ than just the CPI.
Housing is a major driver of the annual inflation figure, with the price of new dwellings rising 10.5% over the previous 12 months. These ballooning construction costs are driven upwards by materials and labour shortages. This stems from a few sources, including the HomeBuilder Grant which caused a surge in new dwelling construction, the bushfires which ravaged our plantation regions, and high international supply costs. Flood inflation has also increased the stress on house construction – as supply side capacity is failing to meet the ever increasing demand. Rent prices increased by 2.8% this quarter alone across Australia. This is consistent with falling vacancy rates and rising mortgage repayments, which force prices up and bleed the wallets of renters.
The shambolic state of our energy market is creating a cash crunch of a scale we haven’t seen in over 10 years. Gas and other household fuels rose by 10.9% and electricity by 3.2% this quarter alone. Everyday Australians will find themselves in the tricky spot of choosing to cool their homes over summer or trimming precious dollars off the energy bill. That is an opportunity cost no family should have to consider in an advanced and resource rich economy like Australia’s.
Over the past twelve months, furnishings, household goods and services rose 7.7%. This is mainly due to supply chain problems exacerbated by covid-induced worker disruptions, manufacturing constraints in China and throughout Asia, and resource shortages making inputs more difficult to procure. In this category, other non-durable household products (+16.2%) and Furniture (+11.4%) were the main contributors.
But this is where we approach one of the limits to the CPI’s usefulness. It does not give us a complete picture of the impact rate rises are having on people’s bottom lines. Calculations from RateCity show that the rate rises leading us to a 2.5% cash rate had already added nearly 30% to mortgage repayment amounts on a 25 year loan. This puts households in a cruel situation where the fastest growing cost of living is actually servicing a mortgage. Furthermore, these rate rises aren’t even working on combating the biggest drivers of today’s inflation. The increases in food, construction, and commodities are caused by more than just hot demand. Global factors including the war in Ukraine, China’s manufacturing squeeze, and supply chain problems are all at fault.
The ABS noted that annual, non-discretionary inflation jumped from 7.6 per cent in the June quarter to record highs of 8.4 per cent in September. While the cost of life’s nice to haves are rising strongly, it is the price of necessities that is really driving the inflation crisis.
Non-discretionary spending is consistently below the headline inflation rate. The cost of restaurant meals increased by 6% while takeaways went up by 6.6%. Furthermore, the cost of going to the theatre, a movie, or a sporting event actually fell by 0.8%. These areas employ millions of Australians and have a significant impact on our overall quality of life. So the CPI as a measure of cost of living does not encapsulate all of the components that make up people’s lifestyles in Australia.
While the RBA is gunning for a drop in inflation, it is hurting people’s ability to enjoy the goods and services which aren’t actually contributing to the problem. The RBA’s rate rises will force some Australians to reduce their non-discretionary spending, which may damage the domestic services core of our economy.
Is it all bad news?
Well, many of the price increases are transitory, meaning they will fade away over time rather than embed themselves in our financial system. The 2-year market economists’ expectations of future inflation has remained unchanged since the March Quarter of 2022 and the RBA’s Break-even 10 year inflation rate has fallen to 2.2%. These are important signals that the current inflationary bout we are experiencing won’t persist indefinitely.
The price shocks in construction will fall away as supply chains regain their footing and demand begins to fall. Higher interest rates and the ending of government construction grants will drive people to delay their planned renovation or building projects. Furthermore, automotive prices have begun to fall as global prices soften. In the September quarter they fell 4.3%, with the annual movement down to 18% from the March peak of 35.1%. caused by one-off events or sudden shocks to the economy. A more stable commodity market also promises some respite for manufacturing and processing companies, opening the door to falls in discretionary categories. This can be seen in clothing and footwear, which saw prices fall by 0.2% from the June to September quarters.
The CPI is a sobering reminder of the important role economics plays in our daily lives. It is a critical tool for policy makers and economists seeking to keep tabs on the state of the economy. We can think of it like a window, which the RBA’s board can look out from to see the impact of their decisions.
Except rather than bustling Martin Place, the view is of $10 lettuce and $8 milk.