Inflation versus the Price level

The ‘cost of Living crisis’ is often cited as a key factor in explaining the poor performance of incumbent governments in recent elections, most notably in the US Presidential poll. Yet the major Central Banks are now loosening monetary policy with more easing expected (the ECB deposit rate is currently priced to fall to 2% from a high of 4%) which highlights the difference between inflation rates and the price level. It seems clear that it is the latter which matters to electorates, and hence politically, while the former guides central banks and money market expectations. It is also no doubt somewhat galling for governments to shoulder the electoral blame for rising prices, the control of which they handed over to independent central banks, who face no sanction.

In Ireland’s case the annual change in the CPI for October was just 0.7% (and only 0.1% on the HICP measure), down from a peak of over 9% two years earlier, and prices are actually lower than a year ago in four of the twelve index divisions.Yet consumer prices as measured by the CPI are 21% higher than four years ago. That is an average change and while some prices have risen by a similar amount (food is up 22% and alcoholic drink 24%) other components have seen much larger increases,.

Housing and Utilities are 49% higher, driven by an 82% rise in mortgages , a 70% rise in utility prices and a 33% increase in rents. Transport costs are 25% higher, with fuel prices up 29%, but airfares have actually more than doubled in the four years (+106%) .

Surveys consistently show that consumers overestimate the current inflation rate so the general public probably perceive that the increase in the price level has been even higher than shown by the above figures. Wages have risen too of course, and are currently outstripping inflation, but over the four years average earnings have actually lagged prices, rising by 18% against the 21% CPI increase.

The spike in consumer prices has been a global phenomenon of course and most governments can point to very low unemployment rates by historical standards but it seems electorates now take the latter for granted but punish governments for the rise in their domestic price level, particularly as it was last seen forty years ago and so outside the experience of many voters..

Measuring Irish Inflation

Eurostat publishes inflation rates for the EU and the euro area each month and also issues a flash estimate for the EA , normally around two weeks before the final release. The flash figure now includes all EA member states, so an estimate for Ireland is available ahead of the official release here by the CSO.

The estimate is for the Harmonised Index of Consumer prices (HICP) , the official EU measure , which can differ from the domestic measure as used by the respective member states. For example, German inflation in April was 7.4% on their Consumer Price Index (CPI) against 7.8% on the HICP measure.

Most CPI are similar in terms of general components but differ in regard to measuring specific items, notably housing costs. The idea of the HICP is to use a standard methodology , so some items included in the CPI may be excluded from the HICP and this will also impact the component weights.

In Ireland’s case the CPI has a number of largely service items excluded from the HICP, amounting to over 6% of the CPI. These include the Local Property Tax, motor and dwelling insurance, motor tax and building materials. The most significant exclusion though is mortgage interest which has a weight of 2.76% and that component largely explains any significant difference in the two indices over time ,although that has not been a feature in recent years.

For example, the annual inflation rate in March on the CPI reading was 6.7% against 6.9% on the HICP measure. Two components,Housing and Transport, made a 5.2 percentage point contribution to the CPI (i.e. accounting for 78% of the total inflation figure) while the corresponding contribution to the HICP was 5.3 percentage points or 76%.

The difference can be sizeable though in periods when the ECB is changing its policy rates. For example, mortgage rates plunged through 2009 and Irish CPI inflation that year was -4.5%, against -1.7% on the HICP measure. As we now appear to be on the cusp of a tightening cycle from the ECB it is likely that CPI inflation will be higher than the HICP equivalent in the next few years as variable mortgage rates are still the dominant factor in outstanding mortgages here, despite the popularity of fixed rates in new mortgage loans.

The CPI is the ‘official measure of inflation for Ireland’ according to the CSO so in that context it is curious that rent controls last year were initially linked to the HICP and not the CPI, with the former not capturing any change in mortgage costs. The surge in inflation in 2021 prompted a change anyway, with the limit at a max of 2% or the HICP inflation rate if lower, which implies a significant fall in real rents given the inflation outlook, particularly if using the CPI as deflator.