Monday, August 1, 2011

The CPI is not a credible basis for policy action

TOMORROW the Reserve Bank board will decide whether to raise Australia's interest rates, lower them, or leave them unchanged. The consensus among economists and markets is that it will leave them unchanged. You hope they're right but it's not certain.

There is no data the Reserve focuses on more than the consumer price index. Its job is to keep inflation low, and the economy growing. The CPI measures whether or not it is succeeding. If inflation starts climbing too fast, it signals that interest rates need to rise.

Last week's CPI figures seemed to send that signal. The CPI climbed 0.9 per cent in the June quarter, and 3.6 per cent in the year to June well above the Reserve's target to keep inflation, on average, between 2 and 3 per cent over the long term.

Banana prices had a bit to do with that. But what really mattered was that the Reserve's measures of underlying inflation rose 0.9 per cent in the June quarter, after similar rises in March. The annual growth in underlying inflation was within the target range, at 2.7 per cent, but in the first half of 2011 it grew at an annualised 3.5 per cent again, well above the target.

Bankers Trust chief economist Chris Caton summed it up well. If this was the only data you had on the economy, he said, the Reserve would have a clear-cut case to raise interest rates. But it is not the only data we have. And the closer you look at it, the less clear-cut the case is.

The other data tells us that the economy is in a weak condition, outside mining and mining investment. That means the surge in underlying inflation is more likely to be a passing blip a rebound from very low rises in 2010 than the start of a dangerous rise.

A close look at the inflation data confirms this. The weightings given to items in the CPI are based on an old survey of household spending. But the Australian Bureau of Statistics changes them to reflect price rises and falls, assuming that we keep buying the same quantities of goods regardless of price changes. That defies reality, and over time, creates a bias that overstates the inflation rate, as the index increases the weight of items that rise in price, and decreases the weight of items with falling prices.

(We leave aside the third reason to be wary of pulling the interest rate trigger: the slowing global economy, and the serious risks facing it as a result of the prolonged budget standoff in Washington, and inevitable debt defaults by governments in Europe. This is no time for crazy braves.)

What do we know about the economy that should make the Reserve sit and watch for now? Plenty. The strength is largely confined to mining and mining construction. Weakness has now engulfed most of the economy. The broader-based the indicator, the clearer it is.

Jobs growth has slowed to a virtual halt. Even on the smoothed trend figures, the bureau estimates that Australia added just 38,000 jobs in the first half of 2011, compared with 188,000 in the second half of 2010.

There is no light on the horizon. The ANZ job advertisements index says job ads have been shrinking since April. The bureau's employer surveys report job vacancies shrinking since February.

The Reserve's own figures show credit growth has fallen to recession levels. In the first half of 2011, credit basically, the amount we owe the banks rose at an annualised rate of just 3 per cent. Even borrowing for housing is growing at just 5 per cent. Borrowing by business is flat.

Consumer confidence has fallen back to GFC levels. Business confidence is below sea level. In this environment, you need a very, very good reason to raise interest rates and the CPI is not it.

It shows inflation is low in most of its 90 sectors of consumer spending. In the year to June, a third recorded falling prices, a third recorded rises within or below the target, and a third recorded price rises above 3 per cent.

It is a similar story even in the first half of 2011. The unweighted median price rise of those 90 items was well inside the Reserve's target zone. But the weighted median was outside it, partly because the index over time overstates our spending on items with rising prices, and understates spending on those with falling prices.

Take bananas and computers. When this series began in 2005, fruit and vegetables comprised 2.1 per cent of our spending, and computers 1.5 per cent. But fruit and vegetable prices have soared since cyclone Yasi, while computers now pack far more power than in 2005.

But the bureau assumes we still buy just as many bananas, even at $12 a kilo, and buy 2005-strength PCs very cheap. So the CPI is estimated on the basis that fruit and vegetables now comprise 3 per cent of our spending, and computers just 0.5 per cent. And that is wrong.

Likewise the CPI seriously overstates our spending on tobacco, and understates spending on mobile phones. And when the weights are wrong, that means the data itself is also wrong.

The Reserve faces a tough call. But it must not jump at shadows. This is a weak economy; it has time to wait. The next CPI figures will be based on a 2009-10 survey of household spending. That will restore the CPI as a credible basis for policy action.