The CPI Is Not A Cost Of Living Index (And Shouldn't Be Treated As One)

With all due respect to the Minister, I think he gets it wrong here (excerpt):

Minister: New index to reflect ‘real’ cost of living

KUALA LUMPUR, March 5 — The Domestic Trade and Consumer Affairs Ministry is confident that a new cost of living index can reduce the people’s cost of living, especially in the context of the price of goods.

Its minister Datuk Seri Saifuddin Nasution Ismail said the current Consumer Price Index (CPI) was not reflective of the real cost of living, especially for the price of goods.

He said the new index would guarantee and identify more accurately readings on price of goods and cost of living.

“All these while, we (the government) have relied on the CPI or inflation index. For example, the CPI or inflation index can be very low, but then it might not be felt by the people in real life.

“So, we (the government) feel that the new index is a necessity to be made the new guideline that will paint a true picture of what is happening,” he told reporters after officiating the 2018 Excellent Service Award here today.

The problem is the assumption that the CPI is a COL index. It isn’t, or at best, it’s a limited subset of a COL index. First understand what a consumer price index actually does – it tracks a fixed basket of consumer goods and services over time. The goods and services included in the index are based on surveys tracking what people actually spend on. Follow-on surveys are conducted to update the basket, again based on what people actually spend on. So the idea that it doesn’t accurately reflect actual prices of goods is a non-starter.

Here’s where the CPI diverges from a COL index – first, since the CPI averages data across the whole country, it would naturally gloss over differences between areas and regions. Given the disparities in income and expenditure between urban and rural on one hand, and differences in tastes and preferences geographically on the other, it’s no surprise that the national CPI would diverge from individual and regional experiences of inflation.

Second, the CPI is laser focused on consumer goods and services, and ignores capital expenditure. Specifically, it only models the consumption portion of housing (in Malaysia, cars are assumed to be “consumption” items), and ignores housing equity. As a result, the CPI includes rent and imputed rent, but not changes in house prices. Mortgage payments would include elements of rent (consumption use and effectively the opportunity cost of buying a house), home equity (the value of the house over and above it’s consumption use), and interest, but only the first element is a part of the CPI (for a more detailed discussion, see here).

I have to keep pulling out this chart to illustrate what I mean (I know it’s a little out of date, but I’m too lazy to dig up the data again):

The increase in the cost of home ownership has exceeded almost every other item in the household budget, including food and petrol.

As a result, the CPI will never be an accurate measure of the cost of living, because it excludes a very major portion of people’s budgets, especially since the home ownership ratio in Malaysia is fairly high. However, this is not equivalent to saying that it is not a good measure of consumer inflation, because all the empirical research on it suggests that it actually does a decent job of it. If anything, the methodology of constructing the CPI results in it usually over-stating inflation, not under-stating it. The problem here is that the cost of living is a mix of both consumer prices (which the CPI tracks) as well as asset prices (which the CPI doesn't).

But saying the CPI isn’t a good measure of the cost of living is like saying my cat is a bad dog because it won’t bark. We're really talking about different animals here.