New inflation values out today - be careful how you interpret this!

     

    TL;DR: When StatsCan measures changes in prices, they do so for a fixed basket of goods - this includes maintaining quality at a fixed level. When the quality of goods increases over time this creates problems - especially when consumers cannot choose to still purchase the lower quality good for a cheaper price - the result is that the actual inflation of this good, likely, is significantly more than the posted rate of inflation.     

    A common argument is that the average household today is better off than John D Rockefeller because we now have access to microwaves and the internet. Thus, this drastic increase in the quality and availability of new goods must mean that we live significantly better lives. The real question is, can we honestly compare the standard of living across such an expanse of time given drastically different goods, and the quality of goods available. 

    Just the same, an attempt at this adjustment is used in calculating the Consumer Price Index (CPI). recognizing that we have access to superior quality goods today Vs what we had 10, 20, or 30 years ago. This improvement in quality must be accounted for in computing the change in the price of a fixed basket of goods. 

    I talk about this a lot with my students - CPI inflation is intended to be a measure of the change in aggregate consumer price levels for a fixed basket of goods to provide information to policymakers regarding how consumer prices have changed year over year. This provides insight as to what has been happening with prices, but it is not the full story and it is not a good measure of the cost of living.

    But first, why is this problematic? This is problematic as the CPI measure of inflation is often used by employers, pensions, unions, and others to determine the change in the cost of living. This leads to the thinking "Oh, CPI inflation was 2% last year, so as long as I get a 2% pay raise I am no worse off". Unfortunately, as we will see - this may not be true. Specifically, your observed rate of inflation may be significantly higher than the reported CPI inflation - basically, the problem comes down to assumed substitutability.

    (This helps to explain why even though wage growth has been slightly higher than CPI inflation, the average wage earner today feels as if their purchasing power is less than it used to be)

    To evaluate this, let's focus on the aspect of CPI inflation, rented accommodation - while shelter costs on whole are weighted as 26.8% of the CPI basket of goods, rented accommodation accounts for only 6.4% of the total CPI weighting (because we assume that most households are owners - however, a similar problem exists for owned accommodation as the problem we discuss here).

    To begin, we can look at the Canadian Mortgage and Housing Corporation (CMHC) historical records showing the median rental price in the Capital Regional District (CRD) from October 2011 through to October 2021 (the latest available published data), this shows that average rental prices have increased by 4.97% on average over the last ten years (source).

    To compare this to the latest CPI inflation information, we see that over the last ten years the rental accommodation aspect of CPI inflation for the CRD has only increased by an average of 1.92% (source).

    So on one hand, we have the CMHC saying that rents have increased by 4.97% annually (on average), while we have Statistics Canada through the CPI saying that rents have only increased by 1.92% annually. Where does this large discrepancy come from? 

    While these two values are computed through different surveys, and over slightly different time periods, it is easy to presume that as both surveys sample from the same population, we should have approximately the same values given the large sample size - that is to say, sampling error does not explain this difference. 

    What does then? Partly it is in how Statistics Canada and all OECD countries compute the CPI. By definition, the CPI is measuring the change in the price of a fixed basket of goods. For some goods, this is not problematic. IE. The price of a litre of milk in 2011 was $X, then in 2021 the price of litre of milk is now $Y - in this case, milk is milk and has not significantly changed over the last ten years.

    But what about when measuring expenditure on other items? Cars, Computers, Cell Phones, Housing? All of these goods have had quality increases over the last decade (a 2021 computer is not the same as a 2011 computer!) As a result, Stats Canada needs to recognize that quality has increased, and thus needs to determine what would be the change in price for a constant quality (fixed basket) rather than the change in price due to the fact that it is a fundamentally new good being sold (again, it would be tough to argue that a 2021 computer is the same good as a 2011 computer). 

    Statistics Canada does this by using a matched-model method to measure pure price changes. That is, attempting to determine what the price of a good would be if we could somehow keep the quality constant.

    While the idea behind this fundamentally makes sense and is necessary - there are some major problems. Often as quality increases, the consumer no longer has the option to obtain the cheaper, original-quality option. For example, as cell phone speed, and features drastically increase each year, you are stuck paying for these features even if you do not want/need them because there are few if any phones on the market that do not include these new improved features. The same can be said for housing or vehicles. In fact, if features (quality) increase substantially while price only increases marginally, this matched-model method may actually report that the price for this good has decreased from year to year! 

    This becomes exceptionally problematic if the consumer does not actually differentiate based on quality. With respect to housing, what if the consumer is primarily concerned with access to shelter rather than access to different qualities of shelter. 

    If this is the case, then shelter becomes homogenous irrespective of quality - That is to say that the potential consumer does not significantly see a difference between low-quality shelter and high-quality shelter. Given the current tightness of the rental (and housing) market, this makes sense - and we would expect to witness similar market prices irrespective of quality. 

    If we take the year built to be a proxy of quality (IE, newer built homes have newer better quality features) we could test this hypothesis by comparing the two possible outcomes:

1. If we witness little if any price difference based on year built, then the consumer primarily cares about the availability of shelter, irrespective of quality. 
2. If we witness newer places renting for higher amounts, then consumers value quality and thus are willing to pay a premium to access higher quality shelter. (If this is the case, then we should be accounting for this change in quality when computing inflation!)

    Likely, we will witness a bit of both happening, so the real question is where are we sitting today Vs. where were we sitting in the past? Well, we find the following (Source)

    How do we interpret the above table? Initially, we find a large spread between old builds and new builds, this would signify that in 2011, there is a desire for quality - renters were willing to pay more for a quality (newer) unit over a lower quality (older) unit. 

    As we move forward to today (2021) we witness that this spread has flattened out. in 2011 the maximum rental price was 43% higher than the minimum, while in 2021 the maximum was only 9.7% higher.  

    This is signifying that renters are caring less about quality than they care about access to units, thus resulting in a reduction in the quality premium. That is to say, while StatsCan, through the CPI, still discounts higher rents to account for increased quality - the renters are not caring about the quality so much as they are caring about access to shelter.

    To summarize, CPI Inflation says that the cost of rental accommodation has only increased by 1.97%  Vs CMHC's reported 4.97%. The reason for the significantly lower CPI inflation increase is due to the fact that there has (on average) been an increase in the quality of rented accommodation. To account for this increase in quality, the price increase must take the quality increase into account in order to compare "apples to apples". This "apples to apples" comparison yields only a 1.97% increase in rental prices over the last ten years. 

    While this method of comparison is preferred to compute changes in prices from an economic and policymaker standpoint, this is problematic when these same metrics are used to compute changes in the cost of living as they will often under-estimate the true change in cost - this is especially true when the consumer does not have the option (or ability) to continue to choose the lower (original) quality option. 

    The crux of the argument is to use caution when interpreting CPI inflation as there are many assumptions that go into these calculations, and the recently reported annual inflation rate of 6.7% (source) may not be telling you what you think it is. 

    Any comments or questions please feel free to message me or comment below.