All Inclusive
The new index called the CCPI(N) is based on the 2002 consumption patterns of all urban households in Colombo.
Data is collected from 12 urban centres in Pettah, Maradana, Wellawatte, Dematagoda, Grandpass, Borella, Kirulapone, Dehiwala, Kotte, Nugegoda, Kolonnawa and Ratmalana compared to seven centres earlier.
Authorities have been unhappy with the CCPI index as it showed high levels of inflation. The index responds quickly to money printing by the government to bridge the budget deficit.
The criticism that the CCPI index is "wrong" came while a country-wide index, the Sri Lanka Consumer Price Index (SLCPI) showed even higher levels of inflation.
In September inflation measured by the SLCPI was 22.1 percent compared to 17.2 percent for the old Colombo index. The new Colombo index showed 16.10 percent.
From May to September Sri Lanka printed 45.2 billion rupees to bridge the budget deficit.
Though the trend was the same, the new index showed about a two percent lower inflation than the earlier Colombo index in some months, and sharply lower amounts at other times. But the index changes seemed smoother.
Why Understate?
Economic analysts say using an index that understates inflation has several advantages to a government.
A government is able to overstate economic growth with an index that understates inflation if it is made the official index for national accounts.
If it is used for monetary policy, the central bank would be able to print more money (have lower interest rates) without its negative effects being discovered by the public.
The government would also be able to underpay savers and provident funds, if the new index is used to index yields of inflation-linked bonds.
The government (and firms) would also be able to underpay workers, if the index is used to index wages. However indices using all households are not used to index wages of workers.
An index based on the consumption patterns of blue collar workers is needed to index wages. Such people spend a higher proportion of their income on items such as food.
Locally produced foods such as vegetables, meat and fish, which monetary economists call 'non tradables', respond quickly to money printing because they cannot be readily imported when domestic demand pressure rises.
As a result, low income earning blue collar workers need cost of living allowances quickly to make ends meet.
Even in the so-called capitalist countries such as the United States, workers wages' are indexed to CPI-W which is based on the spending patterns of the bottom 32 percent of the urban citizens.
Sri Lanka's old CCPI index which is used to index wages had a high proportion of food in it.
Techniques of understating inflation
In addition to using relatively blunt methods such as reducing the weight of items that go up the fastest, countries with central banking regimes use other sophisticated techniques to understate inflation so that more money could be printed:
= Hedonic regression - Discounting a price increase on the pretext that a qualitative increase has taken place which gives more 'pleasure'. The percentage of discount is usually arbitrary.
= Substitution effect - Substituting a rapidly rising product for a cheaper alternative on the pretext that a consumer would switch to a lower priced substitute.
= Increasing the weights of items that change slowly - Such as using rents in place of changes in actual house prices.
= Core-inflation – A controversial concept where the most important but volatile items are dropped altogether from an index. This allows a central bank to delay tightening monetary policy. But when items such as food are dropped from core-inflation, the index no longer reflects the real world.
Core Inflation
"The Central Bank of Sri Lanka, in particular, has repeatedly highlighted the need for an accurate measure of inflation, which is crucial for the conduct of monetary policy," the statistics office said in a statement on the release of the new CCPI(N) index.
The census department has also developed a core-inflation index. Core inflation is not used in well managed countries to actually target inflation, as it is out of touch with reality.
Sri Lanka's core inflation index would drop goods under government price control, the statistics office said. This includes milk powder and LP gas.
Analysts say such a practice is not necessarily negative, despite the index no longer being representative with actual expenses of real people, unless new items are added during episodes of excessive money printing.
But using core-inflation for monetary policy purposes can result in frequent asset price bubbles as happens in the United States.
Most countries with inflation targeting frameworks use basic consumer prices with minor adjustments for interest rate changes or taxes. This is because a legislative inflation target has no meaning unless it can positively impact the daily lives of ordinary people.
Economic analysts say Sri Lanka may be using a relatively unsophisticated method to understate inflation, which seems to centre around reducing non-trable products and increasing the weight of services in the index.
House rents, fees charged for services take time to adjust and can slow the growth of an index, but they do not necessarily understate inflation over the longer term, as most services are also largely 'non-tradable', meaning they cannot be readily imported.
New Zealand, the country that 'invented' inflation targeting, uses a special non-tradables index to base monetary policy decisions. However the target inflation is the CPI that affects ordinary people with an adjustment for value added tax.
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