By: Patrick Kelly

Calculating the rate of inflation is not without controversy. The method used to measure changes in the price of a basket of goods and services can make a difference to the result. So, should the calculation of inflation be the outcome of the best scientific method as determined by experts, or should members of the public get to choose the method that yields the most desirable outcome for themselves?

One aspect of the current fiscal tug-of-war in the US involves the method used to calculate inflation, with a diverse range of stakeholders arguing for retaining a method that returns higher rates of inflation, rather than one that is statistically superior. Similarly, the government of the UK opted earlier this year to continue with an outdated formula for the indexation of public pensions and government bonds – because the arrangement resulted in a higher rate of inflation and therefore higher payouts to these interest groups.

In the US, President Barack Obama has proposed using an inflation measure known as the chained consumer price index (CPI) to adjust public grants and benefits and to adjust tax bands. The Bureau for Labor Statistics, tasked with compiling the CPI and other economic statistics, calls it “a better approximation of changes in the cost of living”. One American senator described it as “a devious and underhanded way to wage class warfare against working families”. So which is it?

All CPIs use the proportions of consumer expenditure for a particular time period as the weights for the different products and services that make up the CPI basket. In most countries, the spending proportions are changed only periodically, giving rise to a fixed-weight index.

The chained CPI is what is known as a superlative price index, where the weights and prices are from the same period. Because consumers adjust their spending habits over time, index and economic theory supposes that consumers will substitute those products which have higher inflation rates with those which have lower inflation rates. The chained CPI continuously updates the expenditure weights, meaning that it tracks the actual changes in the cost of living of consumers in real time.

Where the argument comes to the nub is that the current (fixed-weight) CPI escalator shows a higher rate of inflation than the chained CPI. This is what theory tells us to expect. The fixed-weight CPI therefore actually overstates the inflation rate whereas the chained CPI is a more accurate indicator of changes in the cost of living.

Lobby groups representing the elderly, veterans and the like, have argued strongly that the chained CPI should not be adopted – usually citing the simple reason that it generates a lower rate of inflation and that this has an adverse effect on their constituents. Some advocates in this consortium have suggested that an experimental ‘pensioners’ CPI should be rather used. There is merit to this argument as the basket of goods underlying that index is more closely matched to the purchasing patterns of the elderly (for example less on durables and more on medical care).

In the UK, government decided to retain a statistically flawed index formula in the form of the ‘Retail Price Index’ (RPI) for indexing government bonds and public pensions because it resulted in a higher rate of inflation than the scientifically superior Consumer Price Index (CPI). This decision follows a three-month consultation exercise during which numerous stakeholder groups argued for the retention of the RPI.

While there are a number of coverage differences between the RPI and CPI in the UK, the central point of the discussion is the seemingly arcane matter of the formula used to calculate the price indices at the elementary level. The RPI uses a ‘Carli’ index, which is the simple arithmetic average of price changes. The CPI uses the international norm of a ‘Jevons’ index, which uses a geometric average. The Jevons index is less swayed by a few big price changes (outliers) and is therefore proven to deliver a more accurate picture of average price changes.

In the face of an outcry by those receiving pensions, and also those holding inflation-linked government bonds, the UK Statistics office decided to retain the RPI. It will, as a partial compromise, publish an additional, adjusted RPI measure which uses the Jevons index (RPIJ) and will give this more prominence in public announcements each month.

In these cases, there is no dispute that the proposed inflation measures provide a scientifically more accurate reflection of the rate of consumer inflation. But vocal lobby groups have shouted down what is scientifically superior on the basis of their (biased) perceptions and parochial interests.

Could this be a dangerous portent of a luddite-like future in which populism triumphs over sound statistical method?

• Kelly is Statistics South Africa executive manager: price and empoyment statistics.