6453.0 - Information Paper: Outcome of The 13th Series Australian Consumer Price Index Review, 1997

ARCHIVED ISSUE Released at 11:30 AM (CANBERRA TIME) 12/11/1997

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Report by the Consumer Price Index Review Advisory Group on its Deliberations on the 13th Series Review of the Consumer Price Index (Appendix)
List of Submissions made on the 13th Series Review of the Consumer Price Index (Appendix)
ANALYSIS OF USES OF THE CONSUMER PRICE INDEX (Appendix)

APPENDIX 3: ANALYSIS OF USES OF THE CONSUMER PRICE INDEX

1 The uses of the CPI are many and varied. It is used:

to assess changes in the purchasing power of household incomes;

to construct measures of real income;

to directly adjust some incomes (such as government pensions and benefits and superannuation income);

to adjust fees and charges in a multitude of private and public sector contracts (with references to the CPI appearing in more than 100 pieces of Commonwealth and State legislation alone); and

in the modified form of the Treasury underlying inflation measure, for macroeconomic policy purposes.
So called 'underlying' or 'core' inflation, as embodied in the Treasury measure of underlying inflation, removes from the CPI basket those goods and services for which prices are significantly affected by exogenous factors, to arrive at a measure which reflects price movements which are predominantly influenced by market forces. No user has argued that the 'headline' CPI should be developed with this construct in mind.

2 Analysis of the various uses leads to the formulation of two broad views of what the CPI ought to measure:

changes in living costs actually experienced by households; or

changes in the general price level.
It is fair to say that all users see the CPI as providing a measure of 'inflation' in some sense. These two alternative views of precisely what the CPI ought to measure serve to highlight the differences of opinion about what is 'inflation'.

3 Households tend to think about inflation in terms of changes in their living costs. That is, an individual household's perception of inflation is determined by the extent to which the outlays it is required to make on goods and services change over time. From this perspective, the outlays they incur in respect of meeting interest payments are as valid as those incurred in meeting grocery bills, in so far as changes in either one affects the purchasing power of their money incomes. Accordingly, households generally regard the terms 'inflation' and 'change in the cost of living' as interchangeable. The current Australian CPI is designed to provide the best possible measure of this view of inflation for wage and salary earners, although not necessarily for other types of households.

4 Economists, on the other hand, have a different view of inflation. From an economist's perspective, inflation relates to the contemporary rate of change in the prices of goods and services. While there are some areas of consumer expenditure for which this view differs from the household cost of living view, in the main these are of little practical consequence. The exception is in the area of interest rates. Economists do not regard interest rates to be 'prices' in the same sense as (say) the prices of oranges. While interest rates (and changes in interest rates) are important in their own right, they are more correctly viewed as representing the price of money or the relative price of consuming today rather than in the future. Therefore, economists regard it as inappropriate to include interest rates in any measure purporting to record the contemporary rate of inflation as they say nothing about the current rate of change in prices of goods and services.

5 In general, sophisticated users of price indexes appreciate the theoretical distinctions between changes in the cost of living and price inflation. They recognise that the conceptually desirable properties of price indexes best suited to measuring each of these phenomena are such that it is not possible to design a single index capable of perfectly satisfying both of them. As each construct provides important information about the behaviour of prices in the economy, they both represent legitimate demands on the national statistical system. However, the CPI occupies a unique position on the statistical landscape and there can only be one CPI. Therefore, the key issue is 'which of these views should underpin the design of the CPI?'.

6 If the indexation of incomes and benefits payable to households is intended to preserve the purchasing power of such incomes and benefits, then the index should be constructed to best measure the household view of inflation. While the current outlays approach to constructing the CPI achieves this, it does so only in respect of the CPI population group (i.e. wage and salary earner households) in aggregate. The index may not adequately reflect the changes in the living costs of many households that are now dependent on the CPI for income adjustment. Those households in receipt of social security benefits and superannuation payments for example, have expenditure patterns that differ significantly from those of employee households or households in aggregate.

7 The extent to which differences in expenditure patterns influence the behaviour of price indexes depends on the variation in individual price movements. If prices of all items move at exactly the same rate then differences in expenditure patterns (relative weights) are irrelevant. The more divergent price movements become, the greater the role of expenditure patterns in correctly measuring the aggregate impact of price change.

8 As interest rates do not represent the current price of a good or service, interest rates cannot be expected to move in line with prices of goods and services. Movements in interest rates are often both large and against the trend of current price change. Therefore, differences in the relative importance of interest charges across population groups are likely to result in differences in measures of the change in living costs. For example, in the June quarter 1997, Mortgage interest and consumer credit charges fell by 7.1% while prices of all other items rose by 0.2% on average (resulting in the CPI, including interest charges, falling by 0.2%).

9 Retired persons and households whose principal source of income consists of social welfare payments, incur relatively less expenditure on interest charges than households on average. This can be largely explained by differences in housing tenure, with these households being more likely to either own their principal residence outright or to rent (rather than being in the process of purchasing). The following table presents data from the 1993-94 Household Expenditure Survey which illustrates differences between employee households and households of retired persons or those in receipt of social security benefits.


	Percentage of			Expenditure on
	households in the	Average weekly		mortgage interest
	process of	expenditure on		charges as a
	purchasing principal	mortgage interest	Average weekly	percentage of
	dwelling	charges	income (b)	income
Household type (a)	%]	$	$	%

Age pensioner	5.2	0.67	246.63	0.27
Other social security	11.5	7.71	297.46	2.59
Superannuant	6.5	1.24	430.78	0.29
Employee	42.8	41.53	796.57	5.21

(a) By principal source of income
(b) After tax

10 Although the problem posed by differences in expenditure patterns could be resolved by producing separate CPIs for each of the various population subgroups, this solution is not compatible with the requirement of having only one CPI. Therefore, given a choice between a CPI which excludes interest charges entirely and a CPI which incorporates interest charges with a weight representative of the community as a whole, it is clear that the former provides a better measure of the changes in the cost of living experienced by those households who are particularly dependent on the CPI for income adjustment.

11 Thus, despite the apparent conceptual contradiction, a measure constructed to best measure general price inflation for the household sector as a whole would provide a better measure of the changes in the cost of living of those households who are most dependent on the CPI for income adjustment. The construction of such an index would require adoption of the acquisitions rather than the outlays approach.

12 In addition to providing a better measure of changes in the cost of living of those households in receipt of social security benefits, an acquisitions index covering all households is also assessed as providing a better indicator of the price experiences of other low income households. As such, it would also be a more appropriate measure for input to the process for adjusting the award safety net by the Australian Industrial Relations Commission.

13 Through removal of the volatility arising from the inclusion of interest charges, an acquisitions index should also provide a more reliable benchmark for assessing future price changes for parties negotiating enterprise agreements.

The documents below are formal submissions to the 13th series CPI review made by members of the CPI Review Advisory Group.