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Ever since the official "core" consumer price index was first
published last year, investors have been faced with two inflation
indicators that at times show mixed signals. Which one should be used?
The year 2006 passed us by with the inflation rate for consumer prices
coming in at about 6 percent, roughly at the same level as so-called
"core" inflation. Consumer prices are officially measured by the
Consumer Price Index (CPI), which excludes volatile and
administered-price components.
The picture throughout most of the year was slightly different, though.
Up to October 2006, the discrepancy between the rates of inflation
revealed by the CPI and the core components was significant --
differing by over 5 percentage points following the hike in fuel prices
the year before.
In layman's terms, core inflation is the underlying components of the
overall CPI inflation rate, which is commonly known as headline
inflation.
So, an unbiased measure of core inflation should average the same as
the headline rate over the long run, but with less volatility. Whenever
core inflation diverges from the headline rate, the two should
eventually reconvene at some point. That's why core inflation is often
used to predict headline inflation, and is widely employed by central
banks in many countries as a basis for their interest rate or monetary
policy decisions.
So, if core inflation is widely used as a benchmark by many central
banks, should it also be used by investors as a benchmark in seeking
rates of return on investments?
For domestic investors -- who are concerned about the value of their
money in terms of the actual goods and services that can be bought --
it is common to demand a rate of return on investments that is above
the inflation rate. That is so as to preserve positive real returns (a
"real" rate of return is the difference between the nominal rate of
return and the rate of inflation).
A frequently asked question, however, is which rate of inflation: core
or headline?
In an ideal world, it shouldn't really matter. Since the ideal measure
of core inflation is unbiased, the two choices would yield more or less
similar results. Unfortunately, we do not live in an ideal world;
constructing an unbiased core inflation measure is often a difficult
task.
What is readily available to investors is the official core inflation
figures, published by the Central Statistics Agency (BPS) every month.
The official measure excludes from the CPI the components that are
volatile (usually food and energy), as well as prices that are
administered by the government. How accurately does the official
measure reflect core inflation? Let us look at historical data.
The published official series began in 2002. If in that year, for
example, an investor had demanded a rate of return on his investment
equal to the rate of core inflation, he would be 35 percent richer
today. Meanwhile, if the investor had used headline inflation to set
his required rate of return, he would be 45 percent richer today.
That's a substantial difference of 10 percentage points over the
period, or approximately one-and-a-half percentage points per annum!
A closer analysis would reveal that although the official core
inflation figure does tend to converge with the headline in the long
run, the levels of core inflation diverge from the headline rate over
time.
The reason for this divergence appears to be the frequent occurrence of
one-off shocks in administered prices. So, although spikes in the
volatile components are indeed temporary, shocks in administered prices
are apparently not.
This is actually quite logical. Prices of volatile foodstuffs, such as
rice, may surge at the beginning of the planting season, but they
usually drop after a successful harvest (although often not fully to
their original levels). By contrast, when administered prices, such as
bus fares, rise, they rarely if ever come down again!
A comparison of the levels of core and headline CPI in a number of
other countries, such as Korea, Thailand and even the U.S., also
reveals divergences. However, Indonesia's case seems to be more
pronounced as the country has seen many significant adjustments in
administered prices over the past several years.
Going forward, will the divergence between the core and headline CPI
indexes grow over time? There is no easy answer, but with fuels, such
as kerosene, still selling at less than half of their market prices --
and the electricity subvention standing at over 5 percent of central
government spending -- one would have to ponder really hard before
suggesting otherwise.
If Indonesia continues on the path toward price liberalization, the
divergence between the core and headline CPI rates is likely to
continue to grow over time (unless a miracle happens and oil prices
plunge to where they were 10 years ago, in which case, fuel prices may
well be adjusted downwards).
So investors who use core inflation as a benchmark are exposed to the
risk of ending up with negative real returns on their investments, the
longer the horizon. Therefore, for now it appears to be more beneficial
to use headline inflation in determining the required rate of return on
an investment.
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