Infection and Inflation: Covid-19 and CPI

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How will the difficulties in measuring inflation during the Covid-19 pandemic affect the economy?

The Consumer Price Index (or CPI) is a weighted price index that measures changes in the prices of goods and services that households consume – in other words, the rate of inflation. It is used almost universally and has a plethora of applications – from retail prices to wage negotiations to taxes, benefits and public sector pensions. The Office for National Statistics (ONS) tracks the changes in the prices of goods (e.g. food and cars) and services (e.g. banking and IT services) in a “basket” of items that resembles the spending habits of a “typical consumer.

However, in this unprecedented time of national crisis, the spending habits of a typical consumer have changed considerably. Takeaways, package holidays and recreational services are no longer available, and there has been a surge in demand for personal protective equipment, and digital streaming services. Therefore, the basket of goods and services on which the CPI is based will no longer be representative of consumers’ actual spending habits.

Components of the CPI and their weightings, January 2020 (ONS)

For example, restaurants and hotels take out 9.6% of the 2020 CPI weighting. Yet it would be practically impossible to collect prices for these services, since they are not available right now. Even if the prices in restaurants and hotels could somehow be collected, they will clearly be less relevant and take up a lower portion of consumer spending today than they usually would. This would lead to an inaccurate rate of inflation being recorded.

Furthermore, the business closures caused by the Covid-19 pandemic have made it infeasible to even provide accurate data on inflation. To calculate the CPI, the ONS visits different regions and types of shops across the UK to collect the prices of over 700 ‘representative items’. Price collectors survey the prices of examples of these items each month to see how they are changing, holding constant features such as brand, make and pack size. Price collectors have mostly relied on physical visits to stores to collect prices, however the ONS recently warned that they are no longer able to conduct such face-to-face visits, due to the national lockdown.

Widespread store closures will make it more difficult to measure inflation

Yet another problem is how the ONS disregards multi-buy discounts (such as buy-one get-one-free offers) when collecting price quotes – on the assumption that their use by retailers doesn’t vary much. However, such discounts have been dropped by many supermarkets, for example Tesco has eliminated multi-buy offers, while Waitrose has removed 900 such discounts. Since these are excluded from the ONS’ calculations for inflation, some cost increases will not be recorded. This means that future inflation measures will understate price rises for certain goods and services which might mean increased confusion among consumers.

Additionally, lower-income households will suffer, due to the withdrawal of such promotions (as a 2009 study highlighted that poorer households tend to benefit more than richer ones from such discounts). This could further exacerbate the rise in income inequality driven by the current situation.

Multi-Buy discounts are not included in official inflation figures

This presents a major headache for economists and policymakers, especially central banks – who are already under fire from critics arguing that their huge stimulus packages will lead to hyperinflation. Central Banks cutting interest rates and buying bonds to try and pump more cash into the economy, along with firms and governments issuing more debt could easily lead to a situation where there is a large supply of cash, but a shortage of goods in the economy. This excess cash can simply lead to a spike in the general price level – in other words hyperinflation.

This problem may be even more pronounced in developing countries – for example Russia. The impact of Covid-19, together with the 65% collapse in oil prices due to a demand and supply shock earlier this year may mean that the 2020 inflation rate in Russia is forecasted at almost 10% (compared with a 2% rate in 2019).

Developing countries such as Russia may experience unusually high inflation

The inaccurate and incomplete inflation data available means that governments risk underestimating the extent of financial hardship facing households, especially lower-income households – at a time when many are under immense strain. The nature of price rises may mean that lower-income households will face a bigger squeeze on their incomes than headline inflation rates suggest (as the real prices of essential goods and services may be much higher than suggested by the ‘official‘ numbers).

Furthermore, these short-term inaccuracies may develop into a more serious long-term problem: as current lockdown disruptions may have longer-lasting impacts on people’s behaviour. The relative weights of items in the representative basket will not pick up these changes for up to two years, because of the way the weights in the ‘basket’ are revised. For instance, if people travel less for vacation over the approaching years, then the 4.2% CPI weight for spending on holidays may no longer represent actual spending habits.

Understated inflation figures will lead to more misery for poorer households

This may also have long-term ramifications for government policy. Headline CPI inflation from this autumn will be used to uprate tax thresholds and benefit payments in April 2021 for the Chancellor’s spring budget. Due to the high weighting given to social activities, holidays and restaurants, this year’s inflation figure will underestimate the real increases in the costs of living – particularly for the less well-off. Poor households may therefore end up with a more expensive weekly shopping list, as well as less government support to help pay for it.


References

  1. Delphine Strauss, “Nations struggle to measure inflation as virus disrupts shopping”, Financial Times (2020)
  2. “The impossibility of measuring inflation in a pandemic”, The Economist (2020)
  3. Consumer price inflation, UK: January 2020 (Office for National Statistics)
  4. R. Blundell et al. “Could coronavirus infect the Consumer Price Index?”, Institute for Fiscal Studies (2020)
  5. Rebecca Lake, “Why the Consumer Price Index (CPI) is Important”, Smartasset (2020)
  6. R. Griffith et al. “Consumer shopping behavior: how much do consumers save?”, Journal of Economic Perspectives, (2009)
  7. George Nott, “Supermarkets slash ‘irresponsible’ promotions in attempt to manage demand”, The Grocer (2020)
  8. “How covid-19 exacerbates inequality”, The Economist (2020)
  9. Vineer Bhansali, “Preparing For Inflation: What Can We Do If The Misery Index Turns Up?”, Forbes (2020)
  10. Anna Galcheva, “Эксперты оценили запас прочности экономики России перед эпидемией”, RBC (2020)

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