How is Inflation Measured?
Inflation is an increase in the level of prices ofthe goods and services that households buy. It ismeasured as the rate of change of those prices.Typically, prices rise over time, but prices can alsofall (a situation called deflation).
The most well-known indicator of inflation is theConsumer Price Index (CPI), which measures thepercentage change in the price of a basket ofgoods and services consumed by households.
In Australia, the CPI is calculated by the AustralianBureau of Statistics (ABS) and published oncea quarter.[1]To calculate the CPI, the ABS collectsprices for thousands of items, which are groupedinto 87 categories (or expenditure classes) and11 groups. Every quarter, the ABS calculates theprice changes of each item from the previousquarter and aggregates them to work out theinflation rate for the entire CPI basket.
Box: Calculating Inflation – An Example
To better understand how inflation is calculated we can use an example. In thisexample we calculate inflation for a basket that has two items in it – books and childcare.The formula for calculating inflation for a single item is below.
The price of a book was $20 in 2016 (year 1) and the price increased to $20.50in 2017 (year2). The price of an hour of childcare was $30 in 2016, and this increased to $31.41 in2017.
| Items | 2016 | 2017 | Inflation |
|---|---|---|---|
 | $20 | $20.50 | 2.5% |
 | $30 | $31.41 | 4.7% |
Using the formula, inflation for each of the individual items can be calculated.
- For books, annual inflation was 2.5 per cent
- For childcare, annual inflation was 4.7 per cent
To calculate inflation for a basket that includes books and childcare, we needto use the CPI weights that are based on how much households spend on these items. Because householdsspend more on childcare than books, childcare has a greater weight in the basket. In thisexample, childcare accounts for 73 per cent of the basket and books account for the remaining 27per cent. Using these weights, and the change in prices of the items, annual inflation for this basketwas 4.1 per cent – calculated as (0.73 x 4.7) + (0.27 x 2.5).
How Are Prices Collected?
The ABS collects prices from a wide range ofsources, such as retailers, supermarkets, departmentstores and websites where households shop. Italso collects prices from government authorities,energy providers and real estate agents. For someitems, the ABS has access to data that allows it torecord prices frequently. For example, scanner datafrom supermarkets give information about theprice and number of items a consumer buys in onetransaction. For other items, the ABS records priceseither monthly, quarterly or annually. In total, theABS collects around one million prices each quarter.
How Is the CPI Basket Chosen?
In deciding which goods and services to includein the CPI basket and what their weights shouldbe, the ABS uses information about how much– and on what – households in Australia spendtheir income. If households spend more of theirincome on one item, that item will have a largerweight in the CPI. For example, the ABS includedsmart phones in the CPI to reflect consumerstaking advantage of advances in technology. Dataon household spending across all items is onlyavailable approximately every five years or so.
Underlying Inflation
While Australia's inflation target is expressedin terms of CPI inflation – known as ‘headlineinflation’ – it can also be useful to look at indicatorsof ‘underlying’ inflation. These indicators excludeitems that have particularly large price changes(either frequently or in a given period). Largeprice changes can often be due to temporaryfactors, which are sometimes unrelated to broadconditions in the economy. For example:
- Supply disruptions because of unusualweather: For example, in 2006 Tropical CycloneLarry destroyed banana crops in Queensland.As a result of this significant reduction in supply,the price of bananas temporarily increased by400 per cent.
- Infrequent changes in tax regulations: Forexample, the introduction of the 10 per centgoods and services tax (GST) in mid 2000caused the prices of many items to increase(the Reserve Bank typically shows headlineCPI inflation excluding the effects of these taxchanges).
In contrast, price changes for a broad range ofitems may indicate a shift in economic conditions.The Reserve Bank may decide to respond to this bychanging cash rate target (see Explainer: Australia'sInflation Target). In Australia, the most importantindicators of underlying inflation are the trimmedmean and the weighted median (see Box:Calculating the Trimmed Mean and the WeightedMedian).
The ABS also calculates the CPI excluding volatileitems, which is the average inflation rate of allitems in the CPI basket except for fruit, vegetablesand fuel. Prices of fruit, vegetables and fuel areusually very volatile because they are oftenaffected by supply disruptions, such as unusualweather, or changes in how much oil is suppliedto the world market. The CPI excluding volatileitems always removes the same items, while theitems that are removed from the trimmed meanand weighted median can change each quarter,depending on which items had particularly largeprice changes.
Box: Calculating the Trimmed Mean and the Weighted Median
To calculate the trimmed mean and the weighted median, all 87 items are orderedby their quarterly, seasonally adjusted price change. (Seasonal adjustment means thatprice changes have been adjusted for increases or decreases that always occur at a particulartime of year; for example, high school fees typically increase in the March quarter, so anadjustment is made to spread this out over the year.)[2]
Limitations of the CPI
CPI is not an indicator of the price level
The CPI measures the rate of price changes in theeconomy, but not the price level. If the price indexof bread is 140 and the price index of eggs is 180, itdoes not mean that eggs are more expensive thanbread. It only means that the price of eggs hasincreased by more than the price of bread from aparticular point in time.
Coverage
For practical reasons, the CPI measures pricechanges of items in the metropolitan areas ofAustralia's eight capital cities (where around two-thirdsof Australian households live). It does notmeasure price changes in regional, rural or remoteareas. The CPI also does not take into accountthe differences in spending patterns betweenindividual households. Households are verydifferent and some may spend a lot more on acertain items than others. For example, cars have aweight of almost 3 per cent in the CPI basket, butnot every household owns a car.
Quality changes
The CPI intends to only calculate pure pricechanges. This means the CPI should ignore pricechanges that result from variations in the qualityof items. The quality of items in the basket canvary and new products can be introduced. Forexample, a bag of pasta can become smaller inweight, or the quality of a mobile phone canimprove if its camera is upgraded.
The ABS tries to remove any price changes thatresult from changes in quality or the mix of itemsthat households buy. Continuing with the previousexamples, the ABS would calculate the price ofthe pasta assuming that the weight remained thesame, and compare it with the price in the previousquarter. Calculating the increase in the price of amobile phone due to the improved camera is moredifficult, because there is often limited informationabout how much the price of the phone haschanged because of the better camera. In this case,the ABS would need to estimate the price impactof the improved camera and adjust the mobilephone price. Because the adjustment is only anestimate, it can result in under or overestimationof the pure price change. Services are particularlydifficult to quality-adjust because changes oftenoccur slowly and it is hard to measure by howmuch the service has improved. For example,better x-ray technology at a hospital could betterdetect injuries, but it is difficult to calculate howmuch the improvement in detecting injuries isworth. In those cases, it can lead to quality beingonly partly accounted for or not at all.
Substitution bias
The CPI is affected by ‘substitution bias’. This isbecause the CPI does not adjust for changesin household spending patterns very often (asidentifying such changes for all householdsis a major undertaking). In reality, householdsfrequently change the amounts they spend onitems. For example, if lamb prices rise by morethan beef prices, households might adapt andbuy more beef and less lamb. Not accounting forthis type of substitution in expenditure results intoo much weight being given to lamb in the CPIbasket and too little weight given to beef. Thisincreases (or biases) the CPI compared with anindex that accounts for households substitutingfrom relatively more expensive items to relativelycheaper ones. In the past, updates to the CPIbasket have taken place every 5 or 6 years, andfrom late 2017 onwards, the ABS started updatingthe CPI weights on an annual basis, which will helpreduce the substitution bias in the CPI.
New products
The CPI does not include new products as soon asthey appear on the market. It can often take sometime until the ABS includes them in the CPI basket.This typically occurs once a product has reached ahigh enough market share and is available to mosthouseholds.
Cost of living
The CPI is often used to measure changes in thecost of living, but it is not an ideal indicator ofthis. While the CPI measures price changes, cost-of-livinginflation is the change in spending byhouseholds required to maintain a given standardof living. The ABS publishes other indexes that aimto provide a better indicator of the cost of living.
From 29 September 2022, the ABS commenced publication of a monthly CPI indicator. The monthly CPI indicator provides a timelierread on inflation in Australia using updated prices for around two-thirds of the CPI basket each month. The quarterly CPI remainsthe principal measure of inflation in Australia. See the ABS Information Paper ‘Introducinga monthly Consumer Price Index (CPI)indicator for Australia’ for more information.[1]
The ABS also produces a seasonally adjusted version of the monthly CPI indicator and a monthly trimmed mean. See ‘MonthlyConsumer Price Index Indicator’ for more information.[2]
