Everything Canadians Know About Inflation Is Wrong, Here’s Why

Everything Canadians Know About Inflation Is Wrong, Here’s Why

Everyone’s talking inflation, but how many Canadians know what it means? When the majority of people (including government officials) mention inflation, they actually mean Consumer Price Index. While the Consumer Price Index is a measure of price change over time, the number grossly underestimates the rise of true inflation. If you’ve heard the government mention “inflation” and quote a number that’s much lower than you’re experiencing, here’s why.

Consumer Price Index (CPI)

The most commonly quoted measure of inflation in Canada is the Consumer Price Index (CPI). The only problem is it doesn’t measure inflation, it measures consumer spending behaviour. It’s used by the Bank of Canada (BoC), and the Canadian government to help set policy, and determine pensions. Naturally, it skews much lower and more conservative than reality. Officially, CPI was only 1.6% in the year ending April 2017 – which has many journalists and politicians incorrectly claiming that inflation was only 1.6%. If you’ve been suspicious that inflation is higher, you’re probably right.

Basket Structure

CPI in Canada is determined by Statistics Canada, using a weighted basket of goods and services. 600 goods and services are tracked and broken down into 8 categories that are weighted. The largest category is shelter, weighted at 27.15% currently. Apparently,  Statistics Canada thinks Canadians devoted a higher percentage of their income to shelter in 2009 than in 2015. A breakdown of the other categories are below, and you can see that this weighting is nowhere near your reality.

Note the basket weight for shelter is only 27.15% in 2015. A survey from trillion dollar fund Blackrock found that the average Canadian spends 43% of their income on shelter. Source: Statistics Canada.

Basket Substitution

One of the bigger issues traders and economists have with the CPI is substitution bias. When measuring products for the basket, they’ll substitute what they call “comparable items” for the cheapest one. StatsCan uses the example of coffee and tea. If coffee is cheaper, they’ll use coffee. If tea is cheaper, they’ll use tea. Unfortunately, reality doesn’t work that way. Your millennial ass that’s powered by coffee isn’t going to switch to tea because it’s cheaper. Tracking prices and assuming consumers will always switch to the cheaper product isn’t an accurate way to gauge how the cost of living changes.

Finding Real Inflation

US Economist David Ranson once described CPI as “an official government-massaged measure” and said it doesn’t “detect the onset of inflation as quickly as financial markets.” He believes commodities are a more accurate predictor of inflation, more specifically gold. In his paper Applied Supply-Side Economics, he argues that since gold is the only money that cannot be debased, it becomes the most reliable benchmark of currency. Debased is a fancy word for reduced in value, like when a government spikes the money supply.

Using gold is a much more primitive measure of inflation, but it doesn’t mean it’s less accurate. Price of gold in a local currency goes up, inflationary forces are at work. Price of gold goes down, disinflationary forces are at work. He argues it’s been able to capture inflation up to 6 years faster than CPI.

Now I wouldn’t throw away the use of CPI and strictly start using gold as the single measure of inflation. There’s no single measure that can capture how the cost of living moves. So ask yourself what you’re hoping to understand when you look at inflation. If you’re looking to pay government pensioners a minimal increase, sure CPI works. If you’re looking to save for a house, that 2% inflation number likely isn’t going to be helpful. Instead, use a variety of indicators to help understand the context of the economy.

Over the next few months we’ll be rolling out some new indexes to give more of a variety when trying to gauge inflation. Some will be light hearted and simple, some will be the aggregate of tens of thousands of data points only machines could analyze.

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