Sunday, May 1, 2011

The effect of an understated CPI

Consumer Price Index is not a reliable cost of living indicator anymore. These days it is more of a political tool to be used to temper inflation rather than indicate the level of inflation. Simple stated, the CPI has a major impact on the Reserve Bank interest rate policy, which in turn sets the pace for the economy to slow down or rev up. However, the CPI is anything but fixed and reliable. The basket of goods and services that make up the CPI is constantly revised, often to make it lower than it actually is. Usually the items that cause it to go up are quietly excluded.

The effect of understating the CPI is twofold. One, it allows businesses and large corporations to restrain wage increases. Two, low CPI justifies the Reserve Bank setting low interest rate. This causes the economy to keep firing on all cylinders. Everybody is supposed to be happy. It is a magic bullet. The government gets re-elected, election after election, for doing a good job. Big corporations get low interest rate and a wage-subdued labour force. Migrants are happy to come, and everybody has a job. Of course, something has to give, doesn't it? Sure it does; the inflation genie is looming large behind the smokescreen. So if you are wondering why a 3.3% CPI increase feels more like 30%, you are probably right.

See this interesting article recently published in The Australian:

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