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CPI: How we measure inflation might be wrong, here's why

Composite image of Australian bank note money CPI, and a pregnant woman and a man in a kitchen looking concerned.
CPI doesn't measure the impact of rising interest rates on the household budgets of homeowners.

The Consumer Price Index (CPI) is just a scam right? Certain people I talk to think so.

I tend to get cornered by concerned citizens who believe a grand conspiracy is evident in Australia’s CPI. How can it be just 2 per cent (or 4 per cent, or 6 per cent) when a particular item has risen by 100 per cent?

It might be beef, furniture or their favourite takeaway meal that has doubled in price; they seek my agreement that these official statistics just don’t line up.

Also by Jason Murphy:

While arithmetically CPI is correct, it is also true that it excludes certain items. Second-hand cars aren’t in it, for example, while America includes second-hand cars in its inflation measure, pushing it much higher. Established houses are also excluded in CPI. That is common practice around the world, but still controversial.

What’s more, the boffins who measure the CPI use a basket of goods that is the same for everyone. That isn’t realistic for measuring one person’s experience of price rises. If you don’t smoke, for example, you face a much lower rate of inflation than someone who does. Whereas, if you buy a lot of fuel, you have recently endured a much higher rate of inflation than someone who buys little or no fuel.

Luckily, the Australian Bureau of Statistics (ABS) is onto the problem. They release a living cost index, which is focused on the purchasing power of the after-tax income of households. It measures the actual cost of living for different groups in society, including things like mortgage interest rates and out-of-pocket insurance premiums that CPI doesn’t cover.

The latest living cost indexes were released this week, covering employees, pensioners, self-funded retirees and people on government transfers other than the pension.

Unfortunately, for the conspiracy-minded, the living cost indexes come in even lower than the CPI! While the CPI measures price rises at 7.3 per cent in the year to September, the living cost index says it is 6.3-6.7 per cent.

A graph comparing CPI to ABS living cost indexes for various groups.
(Source: supplied)

Can that possibly be right? What’s going on?

There are two questions here: one is how the groups differ from each other, and the second is how they differ from CPI.

What people buy differs by their stage of life. For example, the cost of health services rose by 0.5 per cent for employees, but fell by 1.5 per cent for pensioners, and fell by 2 per cent for people receiving government payments other than the pension. That reflects differences in purchases by different groups.

For example, while employee households and pensioners spend similar amounts on dental services, pensioners spend far more on pharmaceuticals, medical and hospital services. Price movements in different sectors can create very different changes in cost of living.

The second question is why the living cost indexes are lower than CPI. The main reason is living cost indexes include rents, but exclude the purchase of housing. The CPI excludes the purchase of land, but includes the purchase of newly constructed dwellings. That means building costs for new homes are included in CPI, and they have been very high recently, thanks to high prices for materials like timber.

Building costs are excluded altogether from the living cost index. Instead, it includes mortgage interest rates. Those are extremely pertinent at the moment, because the Reserve Bank (RBA) has both hands firmly on the interest rate lever and is desperately pumping them higher. The living cost index observes that mortgage costs are up a whopping 24.2 per cent.

Employee households have far higher interest rate costs than other types of households because they are far more likely to have mortgages. Here, however, is the great weakness in the living cost index. While it captures the higher prices, it has not yet increased the weight of mortgage interest rates in employees’ cost of living. And, thanks to a succession of interest rate rises, homeowners are paying more each month for their home loans, which for many is their biggest financial pain point in the household budget.

The reason it’s not up to date? The weightings were last adjusted in 2021. At that point, rates were still falling and people were paying off mortgages fast. 2022 is a very different beast, but the next update of weights is not due until December.

With both interest rates and weights due to increase next quarter, the living cost indexes might yet go higher than CPI.

The living cost index is not a conspiracy, but neither is it up to date. Especially not in an environment when prices are changing very quickly. Thank goodness the ABS has introduced a monthly consumer price index update, to complement its regular authoritative release every three months. The monthly series gives us a much more frequent update on price changes.

I’m excited to get updates more often. But I also dread them - regular CPI updates will necessarily contain more statistical noise, and that can only provide more ammunition to those who want to argue the CPI is deliberately wrong.

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