Perceptions of Inflation

Pemandu serves up some thoughts on the CPI from the Ministry of Domestic Trade, Co-operatives and Consumerism (now isn’t that a mouthful?) (excerpt):

Food Price Increases Not as Dramatic as Public Perceives It

Many Malaysians have expressed concern over the increase in price of items in the food basket in Malaysia, seeing it as a knock on effect of the reduction of fuel subsidies. However, the reality is that these are part of a global trend where the prices of goods and services are on the rise.

“The Consumer Price Index or CPI (Indeks Harga Pengguna or IHP) – which is used to measure the average consumer’s cost of living in a country – has increased for developing and developed countries the world over, and Malaysia is no exception,” said Ministry of Domestic Trade, Co-operatives and Consumerism’s Enforcement Department Director Mohd Roslan Mahayudin.

CPI reflects the dynamics of prices in the local economy and is a measure of the average change over time in the prices paid by urban and rural consumers for a market basket of consumer goods and services.

A comparison of CPI figures for the past 3 years shows how prices have increased incrementally. The CPI for food and non-alcoholic beverages in 2011 registered a 4.8 % increase from 2010, whereas the CPI for 2012 in comparison to 2011 increase by 2.7 % and between 2012 and 2013 by 3.6 %.

“The increase in prices of food basket items has been a gradual process, and is a natural effect of market forces of demand and supply,” he said….

It’s a rather pedantic piece (sorry guys!), and wrong on at least one score – the CPI is NOT a cost of living index, because it only covers consumer goods and services. The biggest missing piece is housing, where the CPI only includes rent and imputed rent (the flow of housing “services” consumed), not the overall cost of home ownership (which would include the capital cost). There’s also finance, which would be hard to incorporate.

But rather than talk about the minutiae of prices and price increases, I’d rather talk about perception itself. I’ve been immersed in an introductory audio course on behavioral economics over the last couple of weeks (link here), and there’s a lot of resonance between what I’m learning and Malaysian attitudes towards the CPI and inflation generally.

One aspect is loss aversion, the tendency for people to overweight the probability of loss. Another is confirmation bias, the tendency to only accept data that fits with preconceived beliefs and reject evidence against.Tied up with these is the way the human brain uses heuristics (simple rules) to perceive the world around it and make decisions, an outcome of trying to manage efficiently the overload of information the brain is always having to process.

The bottom line is this: bad events or circumstances tend to have greater weight (or greater frequency) in the mind’s eye compared to reality. When faced with a sharp increase in the price of something we are very familiar with (e.g. breakfast or lunch) – it sticks in the mind. And we generalise the loss of purchasing power associated with that price increase across all goods and services, even against all evidence to the contrary.

Subjective reality blots out objective reality.

A 20% increase in roti canai or nasi lemak suddenly becomes 20% inflation to our minds, even if no other prices budge a whisker and even considering that breakfast is a small portion of our annual expenditure.

This isn’t to say that Malaysia does not suffer from price increases – we do. That 20sen increase in petrol prices is real enough. It’s just that overall inflation is not nearly as high as people seem to think it is, and the CPI is not as inaccurate (or manipulated) as its made out to be.

The range of goods and services that we consume are legion, and there’s no way for any one person to internally track all changes in prices across an economy, which is why we have a CPI. The CPI isn’t perfect (see here for example), but it does a reasonable job.