OUR central banks have their ways of computing the inflation rate. Can we just pluck-and-use the numbers?
Following our article on Inflation Rate, you would now know what is inflation rate and why it matters to investors. But still, the question lingers, “how did the central banks (including Bank Negara Malaysia) compute their inflation rate? Where and how did they source their information?”
The inflation rate is measured as the percentage change of a price index, and it is important to understand how a price index is constructed so that the inflation rate derived from that index can be accurately interpreted. A price index represents the average prices of a basket of goods and services, and various methods can be used to average the different prices. Exhibit 1 shows a simple example of the change of a consumption basket over time.
For January 2010, the total value of the consumption basket is:
Value of rice + Value of gasoline = (50 × 3) + (70 × 4.4) = ¥458
A price index uses the relative weight of a good in a basket to weight the price in the index. Therefore, the same consumption basket in February 2010 is worth:
Value of rice + Value of gasoline = (50 × 4) + (70 × 4.5) = ¥515
The price index in the base period is usually set to 100. So, if the price index in January 2010 is 100, then the price index in February 2010 is
Price index in February 2010 = (515 / 458) × 100 = 112.45 and
Inflation rate = (112.45 – 100) / 100 = 0.1245 = 12.45%
This is a simple example of how our central bank collect a basket of goods price and compute the percentage change in price from one period to another period. There are several types of inflation rate with each computation for difference purposes of measuring economy and policymaker decision. The above is the general computational of inflation rate by our central bank.
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Most countries use a Consumer Price Index (CPI) specific to the domestic economy to track inflation. Exhibit 2 shows the different weights for various categories of goods and services in the consumer price indexes of different countries.
Central banks usually use a consumer price index to monitor inflation, but there are exceptions. The Reserve Bank of India follows the inflation in India using a WPI. Because food items only represent about 27% in the India WPI (much lower than the 70% in the India rural CPI), the rural CPIs can rise faster than the WPI when there is high food price inflation. Besides the weight differences, the wholesale prices in the WPI also understate market prices because they do not take into account retail margins (markups).
The choice of inflation indicator may also change over time. Federal Reserve Board (Fed) used to focus on CPI-U produced by the Bureau of Labor Statistics under the US Department of Labor. Due to its upward biases, Fed switched over to PCE index in 2000, a Fisher index produced by the Bureau of Economic Analysis under the US Department of Commerce. The PCE index also has the advantage that it covers the complete range of consumer spending rather than just a basket.
Stay tuned for our next article on whether we can pick the inflation figures out from central banks without much considerations.
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