Perspective Unlimited

Wednesday, November 14, 2007

The Measures of Inflation

Inflation in Singapore has gone up in recent quarters, prompting understandable anxiety amongst consumers. In the answer to a parliamentary question, the minister stated that consumers could choose cheaper alternatives to minimise the impact of rising prices. I shall not wade into the big debate whether it is a good enough or adequate answer, people have perhaps already made their minds up. But just to highlight some pertinent points concerning inflation measure since I have been reading some pretty inaccurate economics.

Suppose the price of pork goes up relative to fish, the rational utility maximising consumer will switch from pork to fish consumption. This is simply the substitution effect. But the basket of goods making up the Consumer Price Index (CPI) is often kept constant, and hence do not capture this substitution effect (Laspeyres Index). This is true therefore that this measure overstates the impact of price increase on the standard of living.

In other words, holding income constant, the standard of living does not fall as much as the increase in CPI suggests. The only case where the Laspeyres Index does not overstate actual inflation is when all goods in the basket have the same percentage price increase. In that case, there is no substitution effect since relative prices remain unchanged. Political considerations aside, the parliametary answer is essentially sound. Further reading can be found here.

18 Comments:

  • Bart

    Being blunt, there is no way you can convince the parties concerned as they would state that thye should not use the house brands as they are of lower quality irrespective of any wage rise.

    Although for those who are already using house brands, their burden should ameliorated although the easiest would be to look out for discounts.

    Regards
    Wang

    By Anonymous Wang, at 3:35 am  

  • Aiks, things are inflating and my stock are not. I'm digging out some stuff on equities return vs inflation....found something will post on my blog.

    As for inflation, many argue whether the CPI is even representative of typical household expenditure.

    Many things cannot be substituted - bus fares/taxi/ERP, bread, etc. Others are hard to substitute fish taste different from meat. People will spend more rather than make lifestyle changes to avoid inflation.

    I understand your point - but nobody is happy about price increases even if they can in principle switch to cheaper alternatives. I thought inflation is a money supply issue (M3)? The last time you pointed out that Singapore is an open economy & financial hub....so there is little the govt can do about it unlike the US Fed.

    By Blogger LuckySingaporean, at 5:43 am  

  • Hi Wang,

    I understand it is hard for me to convince people. There has been a lot of things written about cost vs standard of living that sound so sensible, but are actually inaccurate. But I agree with Lucky's point, sometimes we overlook the importance of psychology. Consumers may die die want to stick to a certain brand or type of food rather than substitute.

    Lucky,

    You are right, some items have no easy substitute. But equally, there are items in the basket (such as rent as the minister pointed out) that are inflating quickly, but not actually borne by majority of Singaporeans since they have owner-residentship.

    The only weapon MAS has is to appreciate the Singapore dollar further since we import almost everything. Conditioned on high enough pass through, it should mean lower prices. But some competitors have USD peg, so there is also a danger of becoming uncompetitive if S$ rises too much too quickly. So it will be a more difficult balance act for MAS in the next year.

    By Blogger Bart JP, at 9:31 am  

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    By Blogger Bart JP, at 9:31 am  

  • Lucky,

    As for your stocks, I am sure you are still a wealthy man after the recent declines! I told you to get out of the market when STI was at 3600+ post rate cut euphoria but you were targetting 4000.

    By Blogger Bart JP, at 9:33 am  

  • Bart,

    Thanks for your advice. I've been selling. The STI is not too far from 3600, the recent decline is just a small blip in a massive 5-7 year bull market.

    During this period, I ended up accumulating no less that 60 different stocks. I have a real headache selling them. I wonder if I should just dump them all or still hang on to those with good growth stories (ha but growth stories worthless in a recession). The last time I tried using puts to protect myself on the downside cheaply - a protection with an expiry is not much of a protection.

    The market is pretty fiece when it comes to selloffs these days. With the numerous hedge funds operating and hot money sloshing around, there is alot of momentum chasing taking place. The market will head in a certain direction gathering momentum and spring back like a stretched rubberband.I wonder if speculators have "jumped the gun" with their recent selling....even if the US economy is in bad shape, it is not dead yet.

    As an economist, I thought you would believe in efficient markets and random walks. You seem to suggest there is a high probability of the markets moving down. I thought efficient markets discount all visible problems - subsprime mess, economy slowdown, weak US$,....there is nothing new. The market would discount all this in one day not over a prolonged period of 2 weeks.

    I'm taking my money out not because I think the market is sinking but I'm tired of the volatility....it is driving me crazy. As I have night mares getting out at intermediate bottoms, I'll sell over a period to average out. "Sell and regret, but sell anyway", I keep telling myself...sell and don't look back.

    By Blogger LuckySingaporean, at 11:21 am  

  • Lucky,

    I started selling since August, liquidated about 70% of my equities. Some of them shot up during the Sep rally (lots of regret then) but has since come down. Not to say they will not go up again but too much risks for me to stomach.

    I do believe in efficient markets, somewhat. But in my own circumstances and risk-return assessment, the volatility is just not worth the small upside gains since my investment is not large (unlike you). Firms and markets are risk-neutral, but I am not! But I still keep some to maintain a health interest in the market. I am hoping for a big stock market correction for me to enter again.

    By Blogger Bart JP, at 1:37 pm  

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    By Blogger Bart JP, at 1:37 pm  

  • Hi Bart & Lucky

    I have been looking at the market closely, I seriously think the fundamentals are not improving.

    The US job market is slowing down.

    http://www.bloomberg.com/apps/news?pid=20601068&sid=a13CJBae_71I&refer=economy

    There is also the Morgan Stanley report on how there is no such thing as decoupling. I happen to think it made alot of senses.

    http://money.cnn.com/news/newsfeeds/articles/newstex/AFX-0013-20964603.htm

    But doesn't really matter. The assets are all mostly liquidated way b4 the rally.

    I am like Bart waiting for the drop to come!

    By Blogger at82, at 1:57 pm  

  • At82,

    US economy will not improve so quickly - housing busts has far more repercussions than stock market corrections. In my mind, the only unsettled question is how would Asia perform through a US recession. I am marginally optimistic, but would not bet my house on it.

    By Blogger Bart JP, at 2:26 pm  

  • Bart,

    The US economy has never been good anyway. You have to distinguish between stocks and the economy because many of the DOW components are multinationals. The question is not whether the US economy is good but whether global growth can offset the slump in US.

    Having said that I believe stocks will have a tough time in the coming weeks. No thanks to aggressive hedge funds making it worse than it seems. I couldn't believe when I saw Intel falling after it announced a dividends increase. No company will do this unless it is confident of cash flow and for Intel it has a near monopoly for microprocessors. The earlier news on Intel producng a non-silicon chip also generated no buying interest. I remember these things so when Intel drops to $15, I won't forget to buy. I'm still wondering when I get the chance to pull the trigger to buy Citibank.

    At some point stocks will be a buy, you just need to have cash and guts...

    at82,

    Markets have already been decoupled for a long time. Hong Kong gained 40% while US flatlined this year. During a selloff/panic, markets move in tandem. At some point stock pickers will step in to go through the various market and look for bargains. Japan did particularly bad this year while Bombay, Tel Aviv is surging.

    In the past the US economy was alot bigger as a percentage of the world economy, when it sneezes everyone gets a cold. But today, it is less significant. But still it has to stay afloat for us to remain bouyant. Remember while US real estate slumped in 2006 and 2007, Singapore & HK's property hit record levels. Of course there is decoupling once the market anxiety is over. There is no decoupling if the US market plunge 500 pts, everyone will be wake up the next morning and start selling.

    By Blogger LuckySingaporean, at 10:09 pm  

  • Hi Bart

    I'm not sure i understand why the standard of living does not fall. Let's take a hypothetical example in which a consumer maximises utility by consuming 4 days of pork and 3 days of fish. If price of fish increases, then say now the new maximizing point is 6 days of pork and 1 day of fish. Then, won't the utility (and satisfaction) that the consumer derives from his meals fall. i mean you are in effect reducing the variety of his diet.

    More concretely, let U = Utility = function(pork, fish, pork price and fish price, etc). Actually, some variables are redundant, since pork price = function(pork) etc, but doesn't really matter here. Suppose before price increases, U is maximized at U1 = f(p1, f1) where p1 = pork consumed and f1 = fish consumed. Suppose standard of living is measured by utility, so we have, for example, S = U1. Now after price increase, we have f2 and p2 and a new optimal value U2 = S'. So isn't it right to say that standard of living doesn't fall only if S'>=S? But then, that's not likely right? So standard of living falls in general?

    By Anonymous Anonymous, at 11:12 pm  

  • Hi Anon,

    I think you misunderstood me. Of course the standard of living falls (holding income constant) when prices go up. But my point is that with subsititution possibilities, it does not fall by as much as the rise in CPI would suggests.

    The only time there is a fall in standard of living equivalent to the magnitude of CPI increase is (i) when consumer has Leontief utility function - ie he is totally fixed on the mix of consumption and (ii) all goods in the same basket rise by exactly the same proportion.

    The reason why I flag this is because many blogs are rather confused in making this distinction between cost and standard of living. In terms of economics, what the minister said is not wrong. But whether politically it is enough to reassure the consumers is another matter. But let's not confuse the economics from the onset.

    By Blogger Bart JP, at 9:56 am  

  • anon 11.12,

    Bart did not say that the standard of living does not fall. Bart said that the CPI OVERSTATES the effect of inflation on the standard of living. The price of good A may have gone up while the price of good B remained the same. The utility decrease people may suffer from having to switch their consumer baskets to more of B and less of A may for a lot of people, be less than the increased expenditure they would have to suffer from consuming the same amount of A and B. Therefore, decrease in standard of living may be overstated.

    By Anonymous Tristan, at 10:01 am  

  • Thanks Tristan.

    By Blogger Bart JP, at 10:03 am  

  • Does any1 here even knows exactly(including brand, price) what is in the basket of goods making up the CPI? what if the basket is already using the cheapest brand?

    Cheem calculations aside, Bart could well be absolutely correct in theory. I mean, in theory, I could teleport myself *at no cost* to *cheapest hawker centre in Singapore* for lunch but in reality I work in CBD ... and I dun think packing leftover rice with soya sauce is an acceptable alternative.

    NoName

    By Anonymous Anonymous, at 11:15 am  

  • The detailed basket of Spore CPI can be found in the paper: http://www.singstat.gov.sg/pubn/papers/economy/ip-e28.pdf

    Other info on Spore CPI can be found at
    http://www.singstat.gov.sg/pubn/papers/economy.html#consumerprices

    IMHO, I think while Bart may think that rent are not actually borne by majority of Singaporeans since they have owner-residentship, the increased rent may be a reflection of rising housing prices. For a person wanting to buy a flat, the increased housing prices may be a large price increase in itself.

    This may be a small frequency (small no of people affected) but large impact price increases for items such as rent.

    By Anonymous Anonymous, at 2:13 pm  

  • Thanks Anon for the info, quite helpful. Your point on rising asset prices is well taken, I hadn't realise that.

    By Blogger Bart JP, at 8:14 pm  

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