Upcoming CPI re-weighting to lower inflation: Justin Smirk

Upcoming CPI re-weighting to lower inflation: Justin Smirk
Upcoming CPI re-weighting to lower inflation: Justin Smirk

GUEST OBSERVER

New weights could lower the pace of headline inflation by up to 0.4ppt (–0.3ppt core) by end 2018.

Every five years or so the ABS revises the weights in the CPI based on its detailed household expenditure survey. This brings the CPI up-to-date with the latest spending patterns associated with changing technology and individual preferences as well as correcting a substitution bias that emerges over time as spending tends to rise (fall) for items where relative prices have declined (risen).

There is also a drift in the share of the expenditure classes in the CPI towards those that are rising more rapidly and away from the expenditure classes where prices are falling. 

The ABS has estimated that historically, this substitution bias is worth around ¼ of a percentage point on the annual rate of inflation at each re-weighting. 

The ABS is set to re-weight the CPI (the 17th CPI) with the release of the 2017 December Quarter CPI. However, we concur with a recent comment from RBA that looking at the historical impact of re-weighting the CPI may not provide a reliable guide to the upcoming re-weighting. 

Using our bottom-up approach for forecasting inflation out to 2018 and applying our estimate of the revision to the weights we find that our headline inflation forecast is 0.4ppt lower by the December quarter 2018 compared to our existing forecast. We also found that the re-weighting lowers our core inflation forecast by 0.3ppt. 

A big part of this revision to our forecast is due to the lowering of the weight for tobacco in the CPI from our implicit estimate for December 2017 (before re-weighting) of 4.2% to 2.5%. At the 2011 reweighting tobacco’s weight was 2.3%.

As our revised weights are estimated from the best information we have on hand we will do another update post the release of the latest Household Expenditure Survey. However, as we can’t fully replicate the ABS’s methodology will not complete a formal review of our forecasts until the ABS releases the new weights.   

Until then what we can say is that the downside risk to the inflation outlook is somewhat greater than the historical estimate of 0.2ppt and could be as large as 0.4ppt.

Justin Smirk is ‎senior economist, Westpac Group and can be contacted here.

 

Tags: 
Cpi Inflation

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