Monday, February 13, 2012

Refining Canada's CPI Before Bubble Bursts?

Steven Chase and Tavia grant of the Globe and Mail report, CPI retooling could result in big savings for Ottawa, business:

Canada’s statistics agency is refining the consumer price index, a key economic yardstick for matching pensions and salaries to the rising cost of living – and the result could mean sizable savings for governments and corporations that hike payments annually to keep pace with inflation.

Statistics Canada’s consumer price index, known as CPI, is a widely followed gauge of inflation that has an enormous impact on Canadians’ lives. It’s used to determine cost-of-living increases in people’s pay and pensions, as well as government benefits, such as old age security.

For years, however, some economists outside Statistics Canada have argued the consumer price index’s measure of inflation overestimates what’s happening – concerns that echo a longstanding debate in other countries, such as the United States.

Statistics Canada acknowledges that one kind of bias that creeps into consumer price tracking can add as much as 0.2 percentage points to the consumer-price-index measure of inflation – meaning that when inflation is measured at 2 per cent, the true rate would be 1.8 per cent.

The agency is more than 18 months into the CPI Enhancement Initiative, which attempts to improve the precision of its work. Statscan received extra funding to tackle the "measurement bias" – cash that rises to as much as $15-million in the fifth year of the effort – and make the index more attuned to Canadians’ spending habits.

The effort is under way as the Harper Conservatives try to squeeze savings out of government and trim expenses in order to balance the budget by 2015-16.

If Statscan is successful in reducing overestimation of consumer price inflation, then annual increases in public or private wages and pensions indexed to the CPI will end up smaller than they would have been.

This could mean companies have to pay out less in annual wage increases, but it will also offer some cost savings for Ottawa, economist and former Finance Canada official Don Drummond notes.

For instance, the federal government spends about $36-billion annually on old-age-security benefit payments and increases in the program are linked to the CPI index.

If Statistics Canada removes 0.2 percentage points of over-estimation in the inflation rate, then the annual cost-of-living rate increase for old-age security will be that much lower.

It would mean more than $72-million in savings the first year, and the benefits of the freed-up cash would accumulate annually – meaning its value would grow to $144-million in the second year and $216-million in the third.

While Canadians might complain about a reduction in the growth of their paycheques or pension payouts, Mr. Drummond said, they’re just losing what was never theirs: “You were being compensated for some inflation that never occurred.”

Some economists outside Statistics Canada talk of a much bigger over-estimation. A Bank of Canada economist estimated in 2005 that several kinds of “measurement bias” adds as much as 0.6 percentage points to the consumer-price-index reading of inflation – meaning that when inflation is measured at 2 per cent, the true rate would be 1.4 per cent.

Statistics Canada isn’t willing to embrace this economist's estimate, but there's a lot riding on producing a better gauge of consumer price inflation.

The Bank of Canada watches changes in the consumer price index to help decide whether it needs to take action to keep inflation on target. The amount of income Canadians are allowed to earn tax- free rises in connection with the index.

“We really need this measure to be as precise as it’s possible to be,” chief statistician Wayne Smith said in a recent interview.

Statistics Canada says it’s not concerned with how their fine-tuning might affect cost-of-living increases in wages or benefits or pensions. “We’re just trying to produce the most accurate statistic,” Richard Evans, director of Statscan’s consumer-prices division, said in an interview.

Statscan cautions that it does not expect to remove all the measurement bias in its readings.

Statistics Canada monitors the prices of a “basket” of about 600 goods and services purchased by consumers to keep track of increases in the consumer price index.

The main cause of measurement bias is the failure to change the makeup and weighting of items in the “basket” quickly enough to reflect shifting spending behaviour.

“In effect, we end up giving too much importance to the things whose prices are rising and not enough to the things whose prices are dropping,” Mr. Evans said.

Statistics Canada is switching gears to be more nimble, just as its counterparts in other countries have done as they struggle with the same measurement challenges.

It’s moving from updating and adjusting the basket of consumer goods and services every two years instead of every four years. The agency will eventually shift to revising it every year.

Dana Flavelle of the Toronto Star also on why tinkering with Canada’s inflation measurement could trigger lower pay and pension increases:

Canada’s official measure of inflation is getting an overhaul and that could mean lower pay and pension increases in future for the average consumer.

Statistics Canada is revising the way it measures the Consumer Price Index, a widely used basis for cost-of-living increases by employers and government.

The current method is based on a fixed basket of 600 goods and services that is revised once every four years.

As such, it fails to take into account things like the introduction of new products and changes in consumer behaviour, critics say.

The Bank of Canada, whose trend-setting interest rate aims to keep inflation at 2 per cent a year, said the current method contains a number of “measurement biases.”

When the price of beef rises, consumers switch to lower alternatives such as chicken, the central bank notes. New consumer electronics products, such as high definition TVs, tend to fall in price over time but may not even be in the basket. Products, such as computers, change in quality over time. Consumers can buy more computer power for less money, the bank also said.

Thus, the price of goods and services Statistics Canada references may rise by 2 percentage points a year, but the average consumer’s daily expenses may be rising just 1.8 per cent or even 1.4 per cent, critics say.

Statistics Canada says it’s looking at revising the basket every two years, expanding the sample size and adjusting the relative weights of the items in the basket.

The review could result in lower CPI increases in future and that could mean lower pay and pension increases.

The move could save governments and corporations millions of dollars in annual raises but also mean smaller gains for consumers.

The so-called measurement bias could be as small as 0.2 percentage points or as big as 0.6 per cent points, critics say.

In other words, if inflation was previously thought to be running a 2 per cent age year, the revised estimated could be 1.4 per cent to 1.8 per cent.

For public and private sector employees, pensioners and anyone else living on incomes tied to inflation, that could mean lower gains in future.

Some economists argue Canadians have been getting a free ride at the expense of government and corporations.

Now, before you go off and assume this is another 'ploy' by the Harper government to stick it to pensioners and squeeze workers to help businesses, I caution you that Statistics Canada and the Bank of Canada have some of the best statisticians in the world. They are not doing this for political reasons. This issue of measurement biases has been raised before in policy circles.

There is no doubt however that tinkering with the CPI will lower inflation adjustments on pensions and wages, lowering costs for governments and businesses. Labor groups and other interest groups will be fuming, especially following the discussion of increasing the retirement age to 67. Unfortunately, Canadians love whining on pensions and wages (try going Greek for a week!)

But while it's true consumers substitute away from high prices to lower prices, I prefer looking at a typical basket of groceries from one year to the next. Some reporters in Greece did this and they found huge price jumps on all sorts of basic goods like milk, coffee, sugar and meat in the last three years. Anyone who shops for food and puts gas in their car will be scratching their head trying to understand why the official statisticians are tinkering with CPI now.

There is another reason. The Bank of Canada anchors its monetary policy on inflation. True, they look at core CPI - ex food and energy -- but inflation expectations can rise sharply and limit the ability of the Bank to lower rates at a time when Canada's housing bubble is ready to burst.

Interestingly, Canada's mortgage monster maintains that there is little evidence of a housing bubble, but I agree with the Economist, when Canada's subprime crisis hits, look out below.

Of course, if there is a prolonged housing slump, prices will fall as consumers retrench. But again, the price of many basic goods like sugar, corn, coffee, meat and oil is determined by global demand, not internal economic conditions. Someone living on a fixed pension will feel the squeeze and so will the typical Canadian family who is leveraged to death paying off their mortgage. They will get hit on all fronts, especially if housing prices head south.

I expect protests over this CPI tinkering. In the UK, there was a huge backlash when the government switched from RPI to CPI. Labor and pension groups are very sensitive to changes in inflation and rightfully so. If they do not properly account for the rise in inflation, their real wages and pension benefits will get hit.

Below, Adrian Mowat, Chief Asian and Emerging Markets Equity Strategist, JP Morgan Securities says higher-than-expected CPI data in China could impact the recent rally in Chinese stocks. I remain long Chinese solars and Chinese stocks in general but playing close attention to inflation trends in China as any hard landing there will impact the Canadian and global economy.

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