Inflation and the Base Year Effect

A price index is a means of comparing a set of prices as they change over time. Index numbers allow for a comparison of prices with those in an arbitrary chosen reference (base year), a year that current values can be compared against. This base year is usually given a numerical value of 100 or 1000. The index number allows for percentage changes to be calculated between various time periods.

If we look at the last few years some of the current inflation increases has been exaggerated by what are known as base-year effects. What has happened is that annual inflation has been measured against a time during the COVID-19 pandemic when economies were locked down and prices slumped. Therefore the inflation figures around the world have been increasing quite rapidly but soon they will be measured against the current higher prices which should mean a lower inflation figure. Regions such as Europe that rely on imported energy may see a greater fall in inflation than others if the price of fuels like oil and gas were to quickly cool. But that doesn’t seem likely in the current climate especially with the war in the Ukraine and come October the northern hemisphere heads back into winter with greater energy use. The graph above is a little out-of-date in that inflation in the UK is now 9.1% and the Bank of England expect it to exceed 11% in October. The USA has an inflation rate of 8.6% and it is expected to reach 9%.

Central Bank rate increases in 2022
Below are the central bank rate hikes this year and the big question is have they got their timing and rate increases right.

• With the threat of inflation should banks have increased their rates earlier?
• If they tighten too quickly will that tip their economy into recession and a hard landing?
• What is the right rate increase for the current inflation figure?
• How long (pipeline effect) will it take for interest changes to impact the inflation figure?
• These are the challenging questions that central bankers face in today’s environment.

For more on Inflation and Base Rates view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

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Surge in food prices hits developing countries

With the war in Ukraine there have been serious concerns about global food supply especially when you look at the graph below. Main points to consider:

• Russia and Ukraine are both major grain and sunflower oil exporters
• Spring planting near impossible for farmers in battle zones
• Sanctions on Russia agricultural goods

Source: Thoughts from the Front Line – Another Strange Recession By John Mauldin | March 12, 2022

How will it impact developing countries.
The staple diet of many developing countries relies on imports of wheat and sunflower oil – for instance Egypt imports 85% of its wheat and 73% of its sunflower oil from the Ukraine and Russia. Countries in these circumstances have no choice but to not put sanctions on food imports. The Food and Agricultural Organisation of the UN Food Price Index – meat, dairy, cereals, oils, and sugar – rose 24.1% in February compared to a year ago. This price shock will impact developing countries as food takes up a greater percentage of a person’s income in the developing world. In the developed world food costs 17% of consumer spending in contrast to those in poorer countries where it takes up 40% of income.

IMF Blog

Many developing countries subsidise food prices to maintain law and order and avoid its population from starving but with higher food prices how are they going to afford subsidies? There is also the problem of repaying debt as feeding the population will the priority rather than servicing foreign debt. Furthermore there is an opportunity cost – money won’t be spent on eduction, healthcare, infrastructure etc which it was originally intended for.

In getting out a recession consumers and producers make adjustments sufficient to reinstate growth. I can’t see that happening soon. The entire world order is experiencing a shock adjustment — economically, geopolitically, and otherwise. John Mauldin

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Ukraine conflict sees oil prices go above $100

An excellent video from the Wall Street Journal which explains how higher oil prices impact the inflation rate. By pushing up the price of transport this in turn affects the price of goods / services as producers pass on this extra cost to consumers. Although US focused it does go through simple supply and demand theory to explain how the price may fall or rise.

Today Brent Crude Oil prices rose above $105 a barrel (see graph below) for the first time since 2014 after Russia’s attack on Ukraine amplified concerns about supply disruptions. United States is working with other countries including OPEC on a combined release of additional oil from global strategic crude reserves – in theory the supply curve moves to the right to try and reduce prices. Russia is the third-largest oil producer and second-largest oil exporter and low oil stocks and limited spare capacity, will see additional pressure on prices. Furthermore increased demand with a lot of economies coming out their COVID restrictions will put further pressure on prices.

The RBNZ made a forecast that oil prices should head back to around the $80 per barrel mark but that seems to be rather optimistic with the current political climate. What is sure is that higher global oil prices will continue to put pressure on New Zealand’s CPI.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Price indices – mindmap

Useful for NCEA Level 2 Inflation standard and CIE AS Unit 4.

Source: Adapted from Susan Grant – CIE A Level Revision

Inflation – causes and examples from the global economy.

Here is an excellent video from CNBC which includes news clips from the 1970’s and beyond. Below are some of the main points:

• 1960 – pint of milk in the UK 3p. Today 50p
• Cost Push Inflation – today: supply-chain bottlenecks, shipping costs rising, labour shortages
• Demand Pull Inflation – usually associated with an economy operating near full capacity
• Milton Friedman – inflation a monetary phenomenon and the domain central banks.
• With the expansion of money why has there been little inflation recently? Velocity of circulation is not evident – i.e. number transactions.
• CPI – Headline Inflation but Core Inflation is more valuables it takes out volatile components of the CPI which have no reflection on the strength of their economy – e.g. oil. Gives you a better idea of the inflation trend.
• A little bit of inflation is good – ‘Goldilocks’ not too hot but not too cold.
• Hyperinflation – Brazil – 1980-1995. Weimar Republic – issues 100 Trillion D Mark note.
• !970’s – Stagflation – wage price spiral – higher interest rates 20% – trade-off was the higher unemployment rate.
• Central Banks – focus on inflation but also avoid a deflationary environment.

Major contributions to inflation in New Zealand – NCEA Level 2 External

Finishing off the Inflation external standard with my NCEA Level 2 class and came across an ASB Bank publication which outlines what the main drivers of inflationary pressure are in New Zealand. They list 5 categories which are shown below and note that housing and commodity prices are quite prevalent. This would suggest that the government are trying to get the RBNZ to target house prices.

Source: ASB Bank Economic Note

Outlook
It is forecast (ASB) that the CPI will rise to around 2.5% – cost-push and demand-pull factors with strong NZ$ being superseded by higher external costs and prices. The inflation target for the RBNZ is 1-3% with a target of 2% but the inflation figure above the midpoint should be treated the same as when inflation is below the midpoint. Therefore this does not mean that the RBNZ will necessarily raise interest rates.

Source: ASB Bank. Economic Note – 5th March 2021

Changes to the CPI in New Zealand – 2020

The consumers price index (CPI), New Zealand’s best known measure of inflation, measures the rate of price change of goods and services purchased by households. The CPI consists of a basket of goods and services that represent purchases made by households. The goods and services in the basket, and their relative importance, are reviewed every three years to ensure the basket remains up to date.

There are about 649 goods and services included in the basket. They are classified into 11 groups:

• food
• alcoholic beverages and tobacco
• clothing and footwear
• housing and household utilities
• household contents and services
• health
• transport
• communication
• recreation and culture
• education
• miscellaneous goods and services.

These groups are then broken down further into 45 subgroups and then into 107 classes. The CPI is reported each quarter down to the class level.

After a review in 2020 the following goods or services have been added and removed from the CPI

Items that have been included in the basket of goods

Items that have been removed in the basket of goods

Looks like inflation might hit 2% in New Zealand

The ASB Bank produce a very good Economic Report and below are some of the points they make with regard to inflationary pressures – useful for NCEA Level 2 and 3 as well as CIE AS and A2 level. The CPI will be on the rise with higher global commodity prices (see graph below) as well as the weakening NZ dollar which in turn makes imports more expensive.

• Commodity-price related influences are expected to directly contribute around 1 percentage point to annual CPI inflation over 2018. The direct impact is expected to wane.
• The period of retail deflation looks like it might be coming to an end. The lower NZD and pending increases in wage costs could see this component add to inflation. The extent to which prices will firm will depend on retail margins.
• Administered price increases will add roughly half a percentage point to annual inflation despite the impact of the free tertiary fees policy. Higher prices for tobacco and local authority rates seem to be a fact of life: one driven by health objectives, the other by perennial infrastructure demand and a lack of competitive pressure.
• The labour market is likely to become more of a source of price increases. We note that higher wages need not impact on consumer prices if they are offset by a corresponding increase in labour productivity/trimming in producer margins.
• Price increases from the housing group are expected to subside. It is no longer a sellers’ market for existing dwellings. The balance of power for building work looks to be increasingly shifting towards the customer and away from the provider. Rental dwelling inflation is expected to remain moderate.

Breakdown of CPI Weighting

Source: ASB Bank – Economic Note – Inflation Watch 26 July 2018

New Zealand vegetables prices spike in March with bad weather

Tomato, lettuce, cauliflower, cabbage, and broccoli prices rose sharply in March 2018, boosting vegetable prices 9.5 percent in the month after adjusting for typically seasonal changes.

“Vegetable crops have been affected by a run of storms in recent weeks – lower supply (supply curve to the left) due to bad weather usually means higher prices,” consumer prices manager Matthew Haigh said.

“In February, we saw rising prices for lettuce, broccoli, and cauliflower, due to a combination of humid weather and cyclone Gita. As expected, that wet weather has affected vegetable prices in March too.”

Tomatoes rose more than 60 percent in March to $4.65 a kilo. In March last year, tomatoes were 83 cents cheaper at $3.82 a kilo.

 

2017 review of Consumer Price Index in New Zealand

The consumers price index (CPI), New Zealand’s best known measure of inflation, measures the rate of price change of goods and services purchased by households. The CPI consists of a basket of goods and services that represent purchases made by households. The goods and services in the basket, and their relative importance, are reviewed every three years to ensure the basket remains up to date.

There are about 690 goods and services included in the basket. They are classified into 11 groups:

• food
• alcoholic beverages and tobacco
• clothing and footwear
• housing and household utilities
• household contents and services
• health
• transport
• communication
• recreation and culture
• education
• miscellaneous goods and services.

These groups are then broken down further into 45 subgroups and then into 107 classes. The CPI is reported each quarter down to the class level. Each good or service in the basket is assigned an expenditure weight (see definitions under ‘Statistical calculations’) that represents its relative importance in household spending patterns.

As a result of the 2017 CPI review:

• in-car satellite navigation systems have been removed (they were added to the basket in 2008)
• DVDs and Blu-ray discs have gone (added to the basket in 2006 and 2011, respectively) along with the hire of DVDs, set-top boxes, and external computer drives
• MP3 players are out (they were added to the basket in 2006).

“At the same time, we’re seeing increased spending on technology accessories like headsets and cellphone cases. We’ve added these items to the CPI basket as part of the latest review.”

“The CPI basket is really a reflection of New Zealand society and how it has changed over time,” Mr Attewell said.

“We added the electric lightbulb to the basket in the 1920s, televisions and record players in the 1960s, microwaves and car stereos in the 1980s, and MP3 players and digital cameras in the 2000s. As these items go out of fashion they are removed from the basket.”

Housing and food remain the most important items in the basket, accounting for almost half of people’s spending. Housing includes rent, new builds, and other house improvements.

 

CPI in New Zealand – how is it worked out.

What is the consumers price index?

The consumers price index (CPI), New Zealand’s best known measure of inflation, measures the rate of price change of goods and services purchased by households. The CPI consists of a basket of goods and services that represent purchases made by households. The goods and services in the basket, and their relative importance, are reviewed every three years to ensure the basket remains up to date.

There are about 690 goods and services included in the basket. They are classified into 11 groups. The table below shows the CPI in NZ for the September Quarter 2016 with the 11 groups and the final calculation (All groups) being 0.2% for the Quarterly and Annual change.

These groups are then broken down further into 45 subgroups and then into 107 classes. The CPI is reported each quarter down to the class level.

Each good or service in the basket is assigned an expenditure weight (see definitions under ‘Statistical calculations’) that represents its relative importance in household spending patterns. Goods and services that are more important to households are given higher weights and have a greater influence on the CPI. The weight assigned determines how much impact a price movement for a particular good has on the overall CPI. For example, if households spend more on petrol than on milk, a 5 percent increase in the price of petrol would have a greater impact on the CPI than a 5 percent increase in the price of milk.

What is a Price Index?

A price index is a single figure that shows how a whole set of prices has changed over time. A price index uses one number to represent the prices being charged for various goods and services at the wide range of outlets and locations where they are being purchased. The average price level of goods and services in the expression base period are assigned an index number of 1000. This is the benchmark to which average prices in other periods are compared. Thus, if the index number for a period is 1150, prices have increased by 15.0 percent since the base period. Workings below:

Increase in index number = 1150 – 1000 = 150

150/1000 x 100 = 15% 

Reference population

The population coverage of the CPI relates to the expenditure of private, New Zealand-resident households living in permanent dwellings. The reference population covers approximately 98 percent of the usually-resident population. There are no exclusions based on income source or geographic location.

The target population for the Household Economic Survey (HES) mirrors the reference population for the CPI. The HES excludes residents of temporary dwellings and households in very remote parts of the North and South Islands and on offshore islands, including Great Barrier, Kawau, Stewart and the Chatham Islands. Some types of expenditure are also excluded because their price movements cannot be satisfactorily measured nor can they be related to the price movements of items which are price-surveyed. These include works of arts, illicit drugs, pets and other livestock, gambling, most legal services etc.

All prices are surveyed at least quarterly, though many prices are surveyed more frequently due to their price volatility (for example fruit and vegetables are surveyed weekly). The types of outlets surveyed reflect the places indicated as typical in the Household Economic Survey.

Some Definitions

Expenditure weight – The measure of the relative importance of an item in the index basket, based on the expenditure of the item relative to expenditure on all items in the basket.

Index number series – A series of numbers measuring movement over time from the index reference period value.

Index reference period – The period in which the average price level of goods and services is an index number of 1000. This number is chosen to represent the reference period, but the interest is only in the relationship of the other index numbers to it. The index reference period for the CPI is currently the June 2006 quarter.

RBNZ – Steady as she goes.

Although the Official Cash Rate was left at 2.5% today there is still a belief amongst many economist that growth and inflation will prove stronger than forecast and that, as a consequence, interest rates need to be rising now to offset these risks. Stephen Topliss of the BNZ used the famous economist J K Galbraith to describe the frame of mind of Reserve Bank of New Zealand.

“In the short term it is far better to be consistently inaccurate than inconsistently accurate. To err consistently is almost as good as being right”. J K Galbraith

RBNZ has remained steadfast that the strength in the New Zealand dollar and tightening fiscal policy will have offset the inflationary concerns associated with rising domestic demand, in general, and the housing market, specifically. Moreover, the Bank continues to believe that its recently implemented LVR restrictions will have a significant dampening impact on activity and house price inflation. With that in mind, the Bank has consistently stated that it would not raise the cash rate in 2013 and that it would start the process in 2014, with a relatively aggressive follow through.

Inflation – A thief in your wallet. RBNZ video.

Just published on their website, the Reserve Bank of New Zealand has prepared a short video explaining inflation. The video, featuring the Bank’s Head of Economics, John McDermott, explains how inflation is measured and how it manifests itself in everyday life. It also explains the importance of maintaining price stability. Well worth a look.

Understanding Statistics: PPI v CPI

The Producer Price Index (PPI) measures the changes in prices charged by businesses “at the factory gate” for the goods they produce. They are an alternative measure of inflation. Ultimately retailers and distributors will pass on these prices to their customers.

In New Zealand producer price indices divide into two strands: output prices and input prices. Output prices are the “factory gate prices” charged to customers. Input prices are the cost of materials and fuel that manufacturers bear.

In the US, the PPI divides into three: finished goods, intermediate materials and components, and raw materials. The PPI for finished goods is typically the statistic that the media focuses on. Other countries sometimes calculate it differently. Some countries include agriculture as well as manufacturing in the sphere of producer prices. By definition services are not included.

Like the Consumer Price Index (CPI) and its variants, the PPI derives from a basket weighted according to the relative importance of the industry concerned. The basis for the weighting is the value of an industry’s production and how big or small it is in the overall scheme of things. If the widget industry accounts for 5 per cent of GDP, then any changes in the prices it charges its customers will have a 5 per cent weighting in the PPI. Data on prices comes from monthly surveys with recipients selected by means of a stratified random sample. The sample is updated periodically to reflect changes in industrial structure and technology. The index is effectively an average for the month in question. It is usually published about 10 days after the end of the month it covers.

In general terms, the closer the statistic to the final customer, the less volatile it is. So prices of raw materials – including fuel, commodities, feedstock chemicals and materials used in manufacturing – are the most volatile. Prices of intermediate goods and components are less volatile, and prices of finished goods the least volatile. Why is it important for you? One reason stands out. The PPI can be an indicator of future consumer price inflation. But to view it just in this light is an oversimplification – really like comparing apples and pears. This is because the PPI includes capital goods as well as consumer goods, which the CPI does not. Consumer price indices typically also include services, which PPI figures exclude. Having said that, sustained increases (or decreases) in the PPI may be an indicator in general terms that inflationary (or deflationary) pressures are building up.

If so, and though the statistic itself may seem remote from our normal daily lives, it may produce economic policy moves that have a more direct impact on our collective pocket – such as rising interest rates and tighter credit. Conversely, weak PPI data, together with other factors, may encourage the central bank to relax monetary conditions and cut interest rates to attempt to produce a revival in the economy. Recent trends in the PPI have suggested that deflation is more of a risk than inflation.

One problem that policymakers have to contend with is that some components of the PPI – especially input prices – are very volatile on a month-by-month basis. So the interpretation of the figures, and any policy measures that may be taken, needs to take this into account. For this reason too, seasonal adjustment of PPI numbers, though undertaken in the official statistics, is not held to be particularly satisfactory.

In short, PPI indices contain quite a lot of useful information, but much of it is not glamorous or neatly packaged into a number that analysts and commentators can relate to easily. The result is that some of the detail tends to get lost. Commentators are often quick to trumpet any change in any inflation rate as news, even if it is not.

Lies, Damned Lies, and “Argentinian Inflation” Statistics

Share prices and bond markets are moved by variables including market indicators and statistics on interest rates, inflation and unemployment. The variables are important in other ways, too. Interest rates affect mortgages, inflation harms those on fixed incomes and rising unemployment breeds job insecurity. Yet do many of us really understand how the figures are calculated? Do we really know how to interpret them? If we don’t, should we strive to know more?

We certainly should. Many commentators make a good living out of describing and interpreting statistics. Often their comments are commonplace and uninteresting.The pundit industry would collapse if we all knew more about these numbers and could judge them for ourselves. Interpreting market indicators is a minefield. Many indicators are official statistics that relate to economic performance. Although official statistics are usually honestly compiled, their accuracy varies.

While you can generally trust data published by, for example, Statistics New Zealand, you need to be aware of the limitations of the numbers. Take the consumer price index, a measure of “inflation”. Many commentators attach much greater significance to CPI figures than they deserve. The change in CPI from one month to the next may not be highly significant. It may be influenced by unusual factors that only applied in that month. Deducing a trend from one month’s figures can be dangerous. Statistics can also be adjusted and manipulated. Sometimes the adjustments are helpful. In the case of the CPI, for example, seasonal adjustments can be made. These reduce or eliminate the effect of items that vary sharply in price at different times of the year. They smooth out the figures, giving a better view of a trend. A moving average of several months’ figures may give a better view of an underlying trend. But neither of these is a panacea when it comes to interpreting the numbers. The less scrupulous might “annualise” one month’s or one quarter’s figures. But annualising can cause problems. If this month’s figures are sharply at variance with last month’s, then drawing conclusions from the annualised figure could be misleading.

Argentina’s Inflation Rate
For the last few years the Argentinian government has published inflation figures that a lot of people find hard to believe. Expansionary fiscal and monetary policy has caused the economy to grow too quickly which eventually led to higher prices. In order to conceal the higher inflation rates the government resorted to price controls and tampering with the official figures. Some employees of the statistics institute, INDEC, were told to omit decimal points, not round them. According to The Economist, although this doesn’t seem much, when you do the calculations you get the following:

1% monthly rise in the CPI = 12.7% annual rise
1.9% monthly rise in the CPI = 25.3% annual rise

Unions in Argentina use independent statisticians when negotiating pay increases. Surveys from a university show inflation expectations running at 25-30%. When you compare the official (Government) and the unofficial (PriceStats – private provider of inflation rates) you get the following (see also chart from The Economist):

Unofficial annual rate – 24.4% and cumulative inflation since the beginning of 2007 at 137%
Unofficial annual rate – 9.7% and cumulative inflation since the beginning of 2007 at 44%

Confidence in the present government’s economic policy has taken a hit and it will have to earn back the trust of not only its people but also the global community.

Great site for infographics

A hat tip to colleague Richard Wells for this site – Column Five Media – which has some outstanding infographics. I particularly like the following:

* Grenade or Aid – US Military Spending versus Foreign Aid
* America’s Most Bizzare Taxes – Jock Tax, Candy Tax, Crack Tax.
* The CPI Market Basket – How the CPI is calculated and its impact on individuals
* How Coffee Affects the Global Economy – Value of exports and imports of coffee as well as coffee production.
* Europe Trails the US in Productivity – productivity figures for both countries and why Europe is behind. See graphic below.