Inflation is not as simple as it seems

What inflation rate should one use to calculate whether a particular price increase is keeping pace with inflation? Is it legitimate to use various rates of inflation?

Out of a paper set for the postgraduate diploma students at Rhodes University School of Journalism and Media Studies came an interesting set of answers to these questions.

The paper itself arose from a question JMS colleagues Guy Berger, Robert Brand and I discussed over a pizza lunch with some of those postgraduate students in the week of the unveiling of the 2008/08 Budget.

Looking at the increases in social grants in the Budget, we began to wonder whether those increases had indeed kept those grants level with inflation. Were the increases illusory, a slight of hand? It was the kind of question journalists, ever skeptical, routinely ask.

Social grants, after all, are the primary tool for poverty alleviation in South Africa, outside of delivery of cheap or free services and free housing. Evidence is that social grants make a vast difference to the lives of the very poor in South Africa.

The starting point for our discussion was the Budget speech itself.

In the speech the Finance Minister said: "In this budget, we are able to announce several steps in extending social security over the period ahead. The social grant increases this year match or exceed inflation, and take into account the disproportionate impact of price increases on the poor."

He then went on to specify the increases.

"The maximum values of the disability and old age grants will increase by R70 a month to R940 in April this year, while the child support grant will increase by R10 in April and by a further R10 in October, to R220 a month."

Using the question of whether social grants had been adjusted for inflation as a starting point, the Postgraduate students were set the task of using information technology to elicit and examine the kind of information on social grants and inflation that would yield an article for a newspaper or magazine.

What they produced was a stab in the right direction, but all came up with different answers.

The reason was that they all used different inflation rates.

Some used the year-on-year CPIX rate, which is the inflation rate created for inflation targeting. It strips out the effects of interest rate rises on inflation, by not taking into account increases in mortgage bond repayments.

Some used the year-on-year CPI rate, the broadest measure of inflation.

Some used the CPI inflation rate, but used the average rate for the year, as opposed to the year-on-year rate. For example, they used the average rate for 2007 instead of the rate in December 2007.

And some used a weird and wonderful method of calculating inflation, using the difference between the inflation rate a year ago and inflation now, that I simply found unfathomable, especially as there are simpler ways of calculating inflation, using the index.

Were these approaches all valid? My colleague Robert thinks not. He believes that the inflation rate used should have been the Consumer Price Index, the broadest official measure of inflation. CPIX should not be used: it was designed for the Reserve Bank's inflation targeting only, he says.

CPIX has infiltrated our thinking as the main inflation measure to use, because it is the inflation rate that the Reserve Bank employs.

Take the Finance Minister's speech again.

"Supply constraints for goods such as cement and refined petrol and diesel added to inflationary pressures, pushing up inflation to 8.6 per cent in December last year and an average of 6.5 per cent in 2007."

Here Manuel is talking about CPIX, not the CPI.

My belief is that it is valid to use different inflation rates in evaluating price changes, as long as you state clearly what inflation rate you are using and why you are using it.

That said, the inflation rate as measured by the CPI is probably the most useful, because it is most generally used. There should be a central reference point, so that we can all understand what we mean by "inflation" for measuring changes in prices in countries.

It is also useful to have one inflation rate for the purposes of things like wage setting and legal documents, as a useful overview of consumer price indices by the Organisation of Economic Co-operation and Development, the club of the world's rich nations, points out.

The OECD also says that countries have introduced several different measures of inflation for different purposes.

Even if students did pick the "right" inflation rate, as measured by the CPI, should they have used average inflation or year-on-year inflation?
My feeling is that using average inflation when adjusting salaries and grants is unhelpful.

It is not simply an academic question. Suppose your employer were deciding to award increases based on the inflation rate over a year.
For example, if inflation, as measured by the CPI, rose 9% in December compared to December the previous year, you would expect at least a 9% increase in your salary, just to earn the same money as you had been earning in December the year before.

What if your employer proposed to adjust your salary by the average rate of inflation, as measured by the CPI? You would feel cheated, if you knew what he was doing, because the average rate is 7%, a full two percentage points lower than the CPI year-on-year inflation rate.

In a sense then, the year-on-year CPI inflation rate is the actual figure for inflation - I almost wrote "real" figure, which is a word some of the students wrongly used. "Real" in economic jargon means "adjusted for inflation" (it's opposite is "nominal").

Our students should perhaps not have used the average to adjust for inflation, nor should they have used CPIX. Yet this is what Treasury uses.
There was also the question of the period. The most up-to-date, actual inflation figure available on Budget day was the January inflation rate. Using anything else would be speculative.

Trouble is that Treasury used CPIX, not CPI, to adjust for inflation, and they use a forecast average CPIX rate of the fiscal year.

Had anyone bothered to ask Treasury to explain they would have done so.

Asked what inflation rate Treasury used to calculate the adjustment, the head of communications at the National Treasury, Thoraya Pandy, said Treasury used
CPIX, and rounded off the amounts to the nearest 10.

Asked the reason for using CPIX, she said, "We feel that excluding mortgage interest costs make sense since it is volatile and a small part of the spending on the poor at whom the grants are targeted."

She also confirmed, as I suspected, that Treasury used average inflation, over the fiscal year i.e. from end-February 2006 to end-February 2007.

Since Statistics South Africa has not yet published the inflation figure for February, this figure has to rely on the forecast inflation rate for that month to arrive at the average for the 12 months of the fiscal year.

I attempted to write a version of the story myself, and used various inflation rates to show different things.

The story that I came up with was that most of the grants had kept pace with inflation, and were slightly higher than they would be if simply adjusted for inflation. This was the case if one used the forecast average CPIX (the figure that the Treasury chose) as the measure.

Using other, official, measures of inflation, such as food price inflation, the grants looked a lot less rosy.

Using the latest available year-on-year rate of inflation as measured by the CPI, for January, grants had fallen slightly behind.

Using the year-on-year rate of inflation for the low-income groups, a subset of the CPI, it was not keeping up at all.

So why had Treasury not simply made the increases much higher?

The answer must partly lie in the large sum being spent on social grants. At R70-billion (R75-billion with the cost of managing the grants) this is 12% of budgeted spending for the 2008/09 fiscal year, and just over 3% of Gross Domestic Product.

Not only are the grants going up in value, more people will get them. Bringing the age down at which men are eligible for old age, from 65 to 60 (in phases), means more people will in future get these grants, at the stroke of a pen. In January next year, government will extend eligibility for the child support grant from 14 years to 15.

In the light of the financial storm clouds gathering in the world, it must have seemed prudent not to increase grants too much, whatever inflation figure was used, given that they are going to more and more people.

The cynical would say that it is not an election year.