CPI change confuses markets

Yesterday the ABS released a revision to their methodology for seasonal adjustment to CPI subgroups – an outcome of the 16th Series CPI review.  It resulted in a new lower estimate (not a revised estimate) of the trimmed mean and weighted median measures of inflation for the June quarter. News headlines and the foreign exchange markets seemed eager to interpret this as an excuse for the RBA to cut rates in the near future.  I wouldn’t be so fast.

As I have said in the past, the CPI should be interpreted with a dose of caution.  The RBA’s preferred measures of underlying inflation – the trimmed mean and weighted median – need a double dose of caution.

First, a summary of the actual change that occured (eager readers can tackle the whole ABS document here).  Put simply, of the 90 subgroup price indexes that make up the CPI, 20 were seasonally adjusted in the 15th Series (Sept 2005 – Sept 2011), and now 64 will be seasonally adjusted in the 16th Series.

The graph below is taken from the ABS to show one of the subgroup indexes now receiving a seasonal adjustment in the CPI.  It should be quite clear that while intra-year CPI estimates may vary, the year ended CPI figures with and without the seasonal adjustment would be very similar.  Indeed, year-on-year estimates are within 0.1 percentage point at all quarterly readings since 2002.

An increase in the scope of seasonal adjustments in the CPI was requested by the RBA in the 16th Series review, as they believed it better suited their needs for monitoring price inflation.  The intra-year seasonality in the CPI can be seen in the graph below, with typically high March quarters, and typically low December quarters.  The new seasonal adjustment methods soften this pattern, which means the RBA’s request appears justified.

It all seems fairly mundane at this point.  The media actually pounced on a very minor detail – the changes to the intra-year estimates of the RBA’s preferred measures of underlying inflation.  The graphs below show these measures calculated using the old and new methods compared to the headline CPI.

If we look very closely we can see in the lower to graphs the last quarter-on-quarter readings are lower when calculated with the new seasonal adjusments.   The trimmed mean for the June quarter is 0.9% under the old measure and 0.7% under the new measure.  The weighted median is 0.9% under the old measure and 0.5% under the new measure.

Remember, these are not revisions to the estimate, but new estimates using a different methodology.  We can expect that the year-ended measures for both will be very similar (as they appear to be in the above graphs).

But what exactly are these ‘underlying’ inflations measures?  What are they measuring if not inflation?

The short answer is that they aim not to measure the size of inflation, but the breadth of price inflation across the basket of consumer goods and services.  Let us review the calculation of each measure in turn.

To calculate either measure you first rank the subgroups according the their price change over the quarter as shown in the below table.  For the trimmed mean, you ‘trim’ (remove) the subgroups with the lowest prices moves, up to a 15% weight in the basket, and the trim the subgroups with the highest price moves up to a 15% weight.  In the below table you can see all groups labelled (b) are removed from this calculation.  The remaining 70% of the basket is then rescaled to be 100% of the basket, and the price change over the quarter of those remaining subgroups is multiplied by these weights to get a trimmed mean measure for the quarter.  Simple enough?

The purpose of this measure is to exclude unusually large price movements (in both directions) of just a few of the subgroups, which may have quite an impact on the headline CPI.  By excluding these outliers and using the middle 70% of price movements, you can get a feel for how widespread across the consumer basket inflation really is.

The weighted median has a similar purpose.  This measure is easily calculated by ranking the subgroups in order of the price movements, then taking the price change of the subgroup that coincides with the 50% point in the cumulative basket weight.  In the table above we can see that for the June quarter it happens to the change in the subgroup index for house repairs and maintenance.  But it was very close to being the subgroup fish and other seafood, which would have given a 0.6% reading for the quarter instead of 0.5%.

Again, the weighted median is a good measure of breadth of price inflation across the subgroups in the consumer basket.

But these two measures are not particularly informative in isolation.  They suffer from time lags with the headline measure.  This occurs because price changes flow through the economy in particular ways following an expansion (or contraction) in the money supply – as any good Austrian economist would tell you.   They also don’t chain together into a meaningful index, since they include different subgroups at each reading (although the ABS has now done this from 2002 onwards).  For those still reading, it might be of interest to note that the trimmed mean has been the same as the headline CPI on average since 2002, while the weighted median has been a little higher on average (3.1% compared to 2.9%).

So what should markets think of this new measure?

Not much I would think.  As you can see from the above graphs, not only are the quarterly estimates of underlying inflation quite volatile, the change in methodology does not show a consistent bias one way or the other.  Put simply, if the June quarter measures are lower using the 16th series methodology, the September quarter measure is equally likely to be higher.  Personally, I don’t think the RBA will read much into it.  Especially considering how closely they have been involved with this particular change to the CPI.  But given the political cloud under which the RBA operates, it is hard to tell what they might do.  In any case, the September quarter CPI is released on 26 October.


  1. As I have said in the past, the CPI should be interpreted with a dose of caution.

    IIRC the bullhawks showed no such caution when the CPI was initially released. At the time Chris Joye wrote:

    As I have unwaveringly forecast–and reiterated only a week ago–we will get at least one to two rate hikes this year (in fact, we should in theory get three).

    Forget rate cuts absent a total global meltdown. Anyone suggesting such refuses to accept our inflationary (and full employment) reality.

    One thing I do agree with Chris Joye on: CPI should be a monthly affair not quarterly. Its bizarre that we have to wait until the end of October to get a read on inflation in July.

    • [This comment has been edited by the site admin]

      original post
      Here it is in all its glory…

      RBA to hike interest rates at least one or two times in 2011

      Well, as predicted here more consistently and loudly than pretty much anywhere, Australia officially has a major inflation problem. And I mean ‘major’.

      Underlying or core inflation has been running at more than a 3.5 per cent per annum pace over the last six months. That is more than one percentage point above the RBA’s implied 2.5 per cent per annum target, which just happens to be the highest inflation target in the developed world. (Remember, inflation is a tax on your savings).

      As I have unwaveringly forecast – and reiterated only a week ago – we will get at least one to two rate hikes this year (in fact, we should in theory get three).

      Forget rate cuts absent a total global meltdown. Anyone suggesting such refuses to accept our inflationary (and full employment) reality.

      The currency market gets it, which is one reason why the Aussie dollar is currently trading at a near all-time high of 110.35 US cents. Only a couple of weeks ago I flagged the risk of a surge in the Aussie dollar as foreign central banks seek to diversify into high-yielding Aussie government bonds.

      August or September now loom as a near-certainty for the first RBA cash rate increase. And I reckon we will get another one before the year is out following which the RBA can probably sit pat.

      What makes today’s inflation numbers so much worse – we already knew that the cost of living indices were running at a circa four per cent annual pace – is that the June quarter was supposed to be a softer outcome. One where we got statistical payback for the incredibly high first quarter numbers.

      All the economists were canvassing downside risks to their projections for core inflation of around 0.7 per cent. And many economists argued that the first quarter numbers had potentially been dragged up by the floods, even though core inflation is meant to strip out the impact of unusually strong price rises.

      Recall also that throughout the last six months we have had huge currency appreciation (both in USD and trade-weighted terms), which, we were told, should have been deflationary. Indeed, the currency appreciation in the last quarter was much stronger (more than three times as much) as the appreciation in the first quarter.

      Finally, we have had non-stop war stories of the ‘retail recession’ and how there is massive, across-the-board retail discounting.

      Guess what? They were all wrong.

      In the first quarter, average core inflation was 0.85 per cent. In the second quarter, average core inflation was 0.9 per cent (taking the average of the trimmed mean and the weighted median).

      And this is before Australia starts digesting an unprecedented increase in private investment via the commodity price boom and urbanisation of Chindia.

      This is before Australia starts importing more inflation from China where wages and prices are skyrocketing care of a pegged currency and inflationary US monetary policy.

      This is with the benefit of a near 100 per cent appreciation in the currency from the 60-US-cent lows touched in late 2008 and early 2009.

      Glenn Stevens told our parliamentarians at the start of 2011 that the RBA had a history of getting ‘behind the curve’ with respect to inflation, which has averaged an unacceptably high three per cent per annum over the last decade.

      Glenn Stevens told MPs that the RBA had to learn from its mistakes, and that if you waited to remove all risk to your forecasts, if you waited to eliminate all uncertainty (as many have argued they should), it would be too late. The inflation genie would be out of the bottle, so to speak.

      Well, underlying inflation in Australia has been running 40 per cent above the RBA’s 2.5 per cent pa target for the last half year. The RBA is now well and truly behind the interest rate curve. It has not touched rates since November 2010, and rate changes today take around another two years to have their full effect.

      You read it here first. The doves have been quite sensationally blown out of the sky. Rates are heading higher.

      Published: Wednesday, July 27, 2011

      Not a whole lot of caution being exercised there.

    • There is no harm in monthly readings, but they will be subject to more revisions and simply provide 3 times the ammunition for the media and interest groups to push their agenda.

      I did notice that almost every news article about this CPI change called it a revision to the previous estimate rather than an estimate with a new methodology.

      Since the year ended figures using the old and new measure must be approximately the same, the Sept underlying CPI will probably be higher using the new method. No one realised this point.

      Oh well.