The Consumer Price Index (CPI), the most widely known measure of inflation, is often a deflating number - forgive the pun - associated with rising living costs and stretching budgets for households, and conversely increased production and operating costs for businesses. What exactly is CPI? How is it measured? Does CPI, in its current form, accurately capture the growing financial pressures facing Australians, particularly where housing is concerned?

CPI represents a difference in the price of consumption for all goods and services in an economy between two points in time. The difference is then converted into a percentage which is aggregated either yearly, quarterly, or incrementally relative to a set date (also known as indexing). Prices of goods and services are collected from 87 expenditure classes and then sorted into the eleven key groups listed below:

· Food and non-alcoholic beverages

· Alcohol and tobacco

· Clothing and footwear

· Housing (new)

· Furnishings, household equipment and services

· Health

· Transport

· Communication

· Recreation and culture

· Education

· Insurance and financial services.

(Source: ABS, July 2021)

Seems straight forward right? Where we hit a snag is the question of what conforms to consumption? Take for instance the housing group outlined above: under the definition of consumption, costs such as building a new home, rent, maintenance, renovations, and statutory rates are all included in CPI – however purchasing an existing home is not. This is because the purchase of a home is considered a transfer of an asset, rather than consumption of a discrete good or service. Under this rationale, rent payments should reflect the cost of consuming the good or service of a property at a given point in time rather than including the perceived future value. In reality, house prices have grown at a much faster rate than market rents have which brings the validity of this method into question.

This doesn’t mean that established housing has been removed from other measurements. There is a measure which factors the price growth of assets as well, the Select Living Costs Index (SLCI), which includes mortgages over existing homes, credit charges, and gross insurances. The SLCI however uses a different cost approach to CPI – the outlay approach opposed to the acquisition approach. An outlay approach measures the price of goods or services for which payments were made to gain access to those goods or services i.e., the mortgage repayment of a home loan; whereas the acquisition approach measures the price of goods or services acquired according to their total value. In theory, the repayments are more relevant as a cost of living than the overall price of a home, with regular weekly or fortnightly repayments representing the out-of-pocket expenses to the purchaser.

However, this is where we start to run into problems. What happens when the out-of-pocket costs are deflated by an ultra-low interest rate environment? The chart below compares the CPI housing index, the SCLI mortgage interest repayments index, the established housing price index, and the RBA’s cash rate from June 2007 to March 2021 which accounts for the Pre-GFC housing peak, or thereabouts.

From December 2011, declining interest rates have seen the house price index grow at more than three times the rate of the CPI housing index. While this has occurred, the SCLI mortgage interest index has naturally declined consistently with the falling interest rates. The problem being, in the author’s opinion, that neither measure has accounted for households which have taken on additional leverage in order to keep up with the surging housing prices.

It is acknowledged that as a measure of the ‘cost’ opposed to ‘price’ of owning a home, the current methodology is correct, however, to simply exclude the increase in nominal prices may prove to be an oversight in the long term. One possible solution could be to include a measure of established dwelling prices divided by a factor of thirty, equivalent to the term of a typical principal and interest loan to an owner-occupier, which would provide an indication of the costs of owning a property at a certain point in time, rather than stored future value.

In addition to the housing sector, declining interest rates seem to hold a loose, inverse correlation to the increasing costs of essential items such as Education, Insurances, and Medical and Hospital groups. The below chart highlights these groups as opposed to the All Groups index from June 2007 to March 2021.

Growth in these non-discretionary groups has been offset by reductions in discretionary expenditure groups including the clothing, communication, recreation, and games and toys sub-groups, the same such sub-groups which have recorded the lowest rates of inflation. Whilst the aggregate rate of CPI must account for all goods and services in the basket, it is difficult to accurately judge how households distribute and value the items within their own baskets. When essential expenses are increasing at 2.21 times the rate of the CPI index, surely this implies a greater degree of cost pressure than the index would otherwise suggest.

The current methodology used to calculate CPI and inflation has been around for a long time and has never been a perfect indicator for the true increase in prices, however based on reasonable assumptions at the time, it was considered a relevant enough indicator of the overall economy. It may be time that this methodology is reevaluated - when house prices are increasing by double figures in a single year, and essential goods and services are growing at twice the rate of all groups when balanced - the full story appears to be missing a few important chapters.

Nick Price | Analyst | 07 3229 0111

Sky rocketing house prices & low CPI numbers. Time for a rethink?

Be In The Know