Understatement of the rate of inflation

Pakistan has been experiencing double-digit inflation after a gap of eight years. This has motivated the Pakistan Bureau of Statistics to change the base year of the Consumer Price Index (CPI) from 2007-08 to 2015-16 so as to be able to monitor inflationary trends in a more precise manner. However, by definition this time series is available only from 2016-17 onwards.

The basic question is whether the rate of inflation is being measured accurately or there is a downward bias in the rate of change in CPI? This requires an examination of the price trends in individual items. Also, it is essential to compare the trends revealed by the three price indices constructed by the PBS.

The first price index is the Sensitive Price Index (SPI). This index measures the price level of basic consumer goods on a weekly basis. The base year has not been changed and remains at 2007-08. Over 70 percent of the weights in this index are accounted for by food items.

The monthly CPI has 487 goods and services included in it. The major categories are food, beverages and tobacco; clothing and footwear and housing and utilities. The respective 2007-08 weights are 37.5, 7.6 and 29.4 percent. The Wholesale Price Index (WPI) not only covers consumer goods but also raw materials and intermediate goods. It has two groups of food, beverages and clothing and footwear respectively among the groups.

Therefore, the first comparison that can be made between the three indices is in food, beverage and tobacco. According to the CPI the rate of inflation in this group of items is 13.6 percent in October 2019. Exclusion of non-food items from the SPI and averaging over the four weeks of October leads to an estimate of the rate of inflation in food prices of 18.4 percent during the month. The inflation in the food group of the WPI in October 2019 is reported as 12.5 percent.

There are two major conclusions which emerge from this comparison of food price inflation in different indices. First, there are clear indications that food prices are experiencing faster inflation than reported in the CPI. The rate of inflation as reported by the SPI in these prices is substantially higher than that reported by the CPI. A key example will illustrate this point. This relates to the most discussed price today of tomatoes. According to the SPI the four week average rate of inflation in October in the price of tomatoes was as high as 55 percent. However, the CPI reports the rise as only 8 percent in the price of tomatoes during the same month.

Second, the rate of inflation in food prices according to the WPI in October 2019 is somewhat lower than in the CPI. This indicates that retail price margins are also rising. Therefore, there is collateral evidence which supports the view that the CPI currently understates the rate of food inflation in the country.

There are also indications of problems in the estimation of non-food inflation by the CPI. This index reports the rate of inflation in housing rent at only 5 percent in October 2019, as compared to the level in the corresponding month of 2018. This is a surprisingly low estimate for a number of reasons. Any upward adjustment will impact significantly on the estimate of inflation as housing rent has a big weight of almost 20 percent in the CPI.

Housing rent has generally risen faster than the overall CPI over the last six years. On average, the increase was almost two percentage points higher. Further, wages of construction workers and prices of construction inputs are apparently rising much faster than housing rent. The country is actually experiencing a very large and growing shortage of housing. There are, therefore, strong reasons for believing that inflation in housing rents is substantially understated and if proper adjustment is made then this could raise the overall rate of inflation according to the CPI by almost one percentage point.

The third source of potential understatement is in the measurement of energy prices. Electricity tariffs are estimated to have increased by about 10 percent in October 2019. This presumably relates to the tariff for the average domestic consumer. The problem here is that the monthly tariff also includes the adjustment charge, which varies significantly from month to month.

The impact of this inclusion is illustrated clearly by the latest imposition of the fuel adjustment charge for September 2019 of as much as Rs 1.83 per kwh. This adds almost 20 percent to the average tariff for domestic consumers. It will become applicable in November electricity bills. The electricity price used in the CPI ignores the fuel adjustment charge and this could end up in understating the rate of increase in particular months.

The fourth potential source of bias in the estimate of inflation according to the CPI is in the weight attached to prices in different cities to arrive at the overall national estimate for the CPI of a particular item. Currently, the monthly publication, Inflation Monitor, of the SBP reveals that the largest metropolitan city, Karachi, has the highest rate of inflation among cities at 15.7percent. Karachi accounts for almost one fourth of the urban population of the country. As such, unless Karachi is accorded the proper weight there may be some understatement of the overall rate of inflation.

Overall, the CPI currently understates the rate of inflation for a number of reasons. First, there is evidence of a downward bias in the rate of increase in food prices. Secondly, the rise in housing rents is likely to be significantly higher than reported. Third, there may also be a problem in the estimate of the rise in the price of electricity to domestic consumers in particular months. Fourth, the weight of Karachi in the CPI may be understated.

The high rate of inflation has become one of the major reasons for public dissatisfaction with the quality of economic management displayed by the present Government. It has been the result primarily of four actions taken, more or less, simultaneously. These include a steep devaluation of the rupee, heavy additional burden of indirect taxes, escalation in electricity and gas prices and rise in transport costs of goods due to the jump in prices of petroleum products. As such the combined impact on the rate of inflation should have been sizeable.

However, the overall rate of inflation in the CPI is reported as 11 percent in October 2019. For reasons outlined above it is more likely to be closer to 14 percent. However, since the under reporting is more in food and energy prices the 'core' rate of inflation is likely to be less affected and closer to 9 percent. The overall understatement problem in the rate of inflation ought to be carefully examined by the PBS.

(The writer is Professor Emeritus and former Federal Minister)