No. 3 - Department of Treasury - The Western Australian Government

Western Australian Economic Summary2006 No.3Box 1What does the CPI actually measure?The ABS publishes CPI data for the eight Australian capitals on a quarterlybasis. The CPI measures changes in consumer prices over time byreferencing price information from a wide ranging ‘basket’ of consumergoods and services (it is therefore not a measure of economy-wideinflation).This ‘basket’ is of a constant quality and similar characteristics, with goodsand services selected (and weighted as a part of the total CPI) on the basisof typical household expenditure patterns. This means that in calculating anaverage of price changes across all of the basket’s items between periods,some items will be more important than others in terms of their share ofhousehold expenditure (or weight). While these weights are typically fixedbetween quarters, the ABS revises such weights about every five years(typically this follows the release of data from the Household ExpenditureSurvey). This is to ensure the basket remains representative of householdexpenditure patterns over longer periods of time.The CPI’s construction method means that despite rising banana prices,expenditure weights in the basket have remained the same (that is, it is animplicit assumption of the CPI that consumers will keep buying the samequantity of bananas). While this may be the case for some consumers,others may have substituted bananas for cheaper fruit, a behaviour thatthe CPI would not capture. Similarly, higher fuel prices might haveresulted in people driving less. This may mean that the impact of bananaand fuel prices on the CPI may have overestimated the cost of living.However, it is equally important to note that such impacts also work theother way (as prices fall). The sharp rise in banana prices will eventuallyfall as banana plantations in north Queensland recover and suppliesreturn to more typical levels. The Reserve Bank of Australia 1 predicts thatthe unwinding of banana prices (combined with lower petrol prices) willsee the Australian headline rate of inflation fall over the next year with “arate with a two in front of the decimal place relatively soon” notsurprising. Falling banana prices would therefore likely have a similareffect on the Perth CPI (notwithstanding the effect of other pricemovements, especially house prices in Western Australia).Another aspect of the CPI’s construction worth noting in the context ofcurrent price movements is that it measures price changes forconsumption goods and services, rather than for classes of investments.This means that costs associated with housing in the CPI reflect only anyservice (or consumption) components. So for housing, price changesassociated with land, the purchase of established houses, and capitalaccumulation (and imputed rent) for existing owner-occupiers are allexcluded items, while net acquisitions by the household sector areincluded (e.g. those arising from purchases outside the household sector,such as from businesses such as builders and developers, and expansionof the housing volume through alterations and additions).1 Source: The Reserve Bank of Australia, “Measuring Underlying Inflation” (speech, 28 November 2006),http://www.rba.gov.au/Speeches/2006/sp_so_281106.html.18 Department of Treasury and Finance