Written by Andrew Cassar Overend
11 min read
Last Updated on July 7, 2021
Over the past few months we've released extensive content about inflation, its effect on your savings and whether it will be transitory or not.
The traditional measure of goods and services inflation is the Consumer Price Index (CPI) and it is probably one of the most anticipated monthly statistics by investors. This is because it used for assessing the real cost of borrowing for firms, tracking the purchasing power of wealth, calculating the cost of living expenditure adjustments which government needs to fork out, and for determining the true return on investments. It also affects monetary policy decisions, which, in turn influences perceptions on the outlook for the economy and financial assets.
But is the CPI measuring inflation correctly? More importantly, are you using the correct benchmark to measure your real investment returns?
Our goal is to help our community obtain a basic financial education in order to help them fulfill their goals. Subscribe to get notified when we release new educational content!
In this Master Class you will learn:
The CPI is constructed based on a geometric mean of a weighted basket of goods and services which the average person consumes.
The basket of goods and services is quite extensive. It typically includes items which are routinely purchased such as food, energy, rent and hairdressing, as well as non-durable items of consumption like TVs, cars and laptops.
The weights of each of the items are derived from household expenditure surveys and are updated on an annual basis. Weights are devised based on the weight of a particular item in the general basket of goods or services. Here is an example of how weights are derived with 4 people who consume 4 products:
The "Economy" weights calculated in the last column are simply the average of each of the individuals' weights. The highest average weight is for food (37.5%), meaning that a 10% increase in the price of food will have a much bigger impact than an equivalent rise in the price of recreation (with weight 13.75%).
Price developments are assessed using a monthly survey of product prices in several outlets. Because the prices of goods and services surveyed for the CPI are the actual prices paid by the consumer, then CPI is inclusive of VAT and subsidies. Assuming that the weights are held fixed from one year to the next, here is a simplified example of how CPI is calculated:
|Expenditure Item||Economy Weights (%)||Price last year (€)||Price this year (€)||% Change in Price|
In this hypothetical case, the annual inflation rate was just above 1%. Had the weights changed from one year to the next, the second calculation would have been made using the revised weights.
Although the methodology may seem simple on paper, in reality statisticians face notable challenges which resulted in debate about the true accuracy of the CPI. In fact, the methodology used to compute CPI underwent several revisions over the years, and global statistical leaders are still perfecting the methodology.
The following are a few issues which may help frame your opinion on the underlying accuracy of the CPI.
The underlying criterion which justifies an item's inclusion in the CPI is that the item must affect an individual's cost of living. Therefore, the CPI only includes those goods and services which are consumed routinely. Houses and financial assets are not consumed on a concurrent basis by the average individual, meaning that house prices and financial asset prices are not included in the CPI.
On one hand this makes sense, because unless you find yourself searching for a new house to purchase every month, inflation in property prices should not affect your standard of living. Similarly, changes to the stock price of Tesla or Apple neither affects the cost of living of the average individual.
However, the inability of certain individuals to afford certain assets means that wealth inequality is worsening. In fact, the CPI fails to capture widening inequality gaps.
That said, while price rises in assets which require significant cash outflows (like property) exacerbate the wealth gap between those who afford these assets and those who do not afford them, investing in financial assets has become relatively easy and accessible. Trading fees have been significantly reduced, and the ability to purchase fractional shares means that unaffordability is no longer an excuse. All you need is to dedicate the necessary time to educate yourself, and here at Financial Fortify, we'll make sure that you've got that sorted, so sign up now!
One of the major changes in the CPI methodology was the adjustment for quality of the goods and services forming part of the average basket.
Think about it...when the quality of a product or service improves but the same selling price is maintained, then this is an indirect form of deflation . Similarly, when the quality of a product or service declines and the same price is maintained, then this is inflationary, because with the same money you are buying a suboptimal quality product.
For example, annual iPhone improvements need to be accounted for when computing inflation. Teachers have become more effective in delivering their teaching, so when calculating education inflation, an adjustment for this enhanced quality needs to be made. Medical drugs have also become substantially more expensive over the years, but the effectiveness of these medications at serving their purpose has undeniably improved, so this quality needs to be accounted for.
Statistics from MoneyGuru show that between 2,000 and 2,500 food and drink products have shrunk in size since 2012. Due to higher prices of cocoa inputs, chocolate producers have made chocolates smaller while retaining the same price. This needs to be adjusted in the cost-of-living measure of inflation.
Quality improvements adjust the CPI calculations downwards. If say prices of a product increased by 6%, but 1% is related to quality improvement, then the overall inflation is 5%. In the chocolate example, a simple proportion would be applied to calculate the price of the chocolate assuming that the weight remained the same. The Bureau of Labour Statistics provides a useful table documenting which categories are adjusted for quality.
But these adjustments are not always as straightforward to do. How can the quality of medical drugs or education be captured? In these cases, estimates are derived using a technique called hedonic pricing which is beyond the scope of this article.
The substitution bias overstates the Consumer Price Index because it assumes that consumers keep consuming the same product and services irrespective of price changes. Thus, the substitution bias is removed from the CPI by estimating the likelihood that the consumer substitutes an item which increases in price with a cheaper alternative.
In the past, the CPI was calculated as a fixed-basket price index, which means that the basket of goods and services was held constant and tracked over time.
For instance, let us assume we have an economy which only consists of two relatively substitutable products, coffee and cappuccino. Coffee costs €2.00 while cappuccino costs €3.20, and we'll assume that the average individual always buys 2 cappuccinos and 2 coffees a week. Therefore the total weekly expenditure is equal to (€2.00 x 2) + (€3.20 x 2) = €10.40. During the year, cappuccino prices increase by 5% to €3.36 , but coffee remains the same at €2.00. Under the fixed-basket price index, the total expenditure of 2 coffees and 2 cappuccinos would be €10.72, so total inflation is 3%.
Eventually, the methodology used to compute CPI changed to account for the fact that individuals may substitute goods and services that become more expensive with cheaper alternatives.
Continuing with the above example, the way CPI is calculated today assumes that consumers will change their consumption behaviour and start consuming 1 cappuccino and 3 coffees, provided that this provides the individual with the same utility. Therefore, 1 cappuccino will be deducted from the basket of goods, and another coffee will be added. This means that the weighted expenditure will now be (1 x €3.36) + (3 x €2) = €9.36. This means that this individual spends 10% less because of a change in spending patterns.
As you can see, two different methods yield two different measures of inflation. The fixed-price index calculation is fully reflective of the actual price changes in the goods and services forming part of the basket, while the cost-of-living index is more reflective of consumer preferences.
I would argue that the best combination is a mix of both methods. It is not always the case that consumers substitute from a particular good or service to a cheaper alternative due to a price increase. This is because of imperfect information, product loyalty, behavioural biases or simply inconvenience. However, there may be instances where a marginal increase in the price of a good or service causes consumers to seek a cheaper alternative.
It is argued that these controversial revisions to the CPI methodology were purposely implemented because several of the governments' expenses are tied to the cost-of-living adjustment, which is based on inflation rate. Old age pensions, survivors, and disability benefits are indexed to inflation to protect beneficiaries from the loss of purchasing power. Besides, a lower inflation rate allows for looser for longer monetary policy which can create lending and help generate economic growth.
However, these arguments that the government purposely understates inflation have no factual backing. In fact, I would argue that the government may want inflation, because it can actually be the only tool left in governments' arsenal to reduce the gargantuan debt burdens. In our interest rates master class, we explain how inflation reduces the purchasing power of fixed future cash flows. Those who borrowed money with fixed repayment terms actually benefit from inflation, because they will be repaying their debt in money with lower value. To counteract the negative effects of the pandemic, global governments had to raise astounding amounts of debt to finance their expenditure. The only way to dilute this higher debt level is by generating economic growth which pays off the debt, and inflation can help accelerate this growth process by artificially inflating prices. Therefore, global monetary policymakers have made it clear that they are willing to let inflation run hot for longer.
To illustrate, consider an economy made up of one salesman named Sam. If salesman Sam sells 1000 units in a particular year at €2 per unit, then total GDP is €2000. Assume that the following year, Sam raises prices to €3 per unit. Due to higher prices, Sam faces a reduction in demand and only sells 900 units, but total GDP will be €3.00 x 900 = €2700. Although real GDP falls, nominal GDP rises because of inflation. Therefore, the ratio of the debt stock to GDP will fall because of a higher inflation-generated denominator.
There is another issue however. Recall that CPI is calculated based on weights derived from the expenditure trends of the average consumer. Indeed, the weights are based on a household budgetary survey which is updated annually. But individuals of different ages and varying wealth have different spending patterns and spending frequencies. Therefore, the CPI or any other published measure of inflation is unlikely to be reflective of the true inflation you are experiencing.
Your age affects your consumption pattern. The consumption basket of a teenager who lives with his parents and takes the bus to high school consumes a different basket of goods compared to a 30-year old individual who is still repaying college fees, rents an apartment, and uses a car to commute. The inflation rate faced by a 70-year old pensioner differs even further, as a larger proportion of the consumption basket is likely to be spent on travel and health-related products compared to the average individual.
It follows that individuals who spend relatively more on items with larger increases in prices will have a higher personal inflation rate; those who spend more on items with lower price increases or items with price decreases will experience a lower rate of inflation.
Moreover, the inflation rate between the rich and the poor also differs substantially. The poorer people’s consumption basket is largely made up of essential consumables like food, health care and rent. However, the rich person’s expenditure is more geared towards luxurious non-essentials and assets like property, precious metals and financial instruments.
The inflation rate of a wealthy individual is likely to be more weighted towards luxury goods and services, such as cars, yachts, restaurants and jewelry. If these individuals invest in assets on a frequent basis, the consumption basket of these wealthy individuals may also include appreciating assets like art, watches and wine. Because these items are consumed more regularly, any price fluctuations in these assets affect the cost of living of wealthy individuals.
The CPI has its deficiencies, but before dismissing it for good, just be aware that we all have different expenditure trends in line with our age and financial position, which means that each of us has a different inflation hurdle to beat. And this has implications for our overall investment strategy, which should thus be geared at beating our personal inflation rate rather than the official CPI inflation rate.
In fact, some renowned investors like [Michael Saylor]((https://podcastnotes.org/crypto/the-investors-podcast-tip/michael-saylor-preston-pysh-economic-calculation/) even claim that the [hurdle rate to beat is not the inflation rate, but the rate at which currency is being devalued. So if the money supply increases by 15% per annum, then in order to beat the currency devaluation you need to generate at least a 15% return on investment. It goes without saying that the higher the hurdle rate you set out to beat, the higher the nominal investment returns you need to generate. And higher return is usually comes with higher risk, so it is important that you always remain prudent in your investment approach.
Recent PostsWhy it has become more challenging for younger generations to become wealthy and what they should do about it Understanding the economics of the global energy crisis The only investing guide you will ever need Are you rich? Is it possible to have too much savings? Is the reflation trade over? Investment opportunities for 2021 and beyond Best investments for inflation protection Malta - A victim of its own success?