Does CPI reflect the cost of living?

From the start of the year Kenyans, including the media, have been talking about the rising cost of living by looking at the prevailing food prices.

According to the February consumer price index (CPI), the prices of food items such as cooking fat, capsicum (pilipili hoho), Irish potatoes (Irish) and sifted maize flour increased between January and February. In the same period, there was no change in prices of petrol and diesel until March.

Some analysts are now questioning whether the consumer price index really reflects cost of living.

This question was being asked before the effects of the Russia-Ukraine war, which has seen the prices of crude oil as well as wheat sharply shoot up.

This conversation is expected to be with us for a while. As we head into elections, the economic effects of uncertainty will also be checking in, especially inflation.

To start with, the consumer price index represents the average prices of a basket of goods and services from a base year. The prices are collected monthly and various methods are used to average the changes.

In different countries, the consumer price indexes have different names and different weights on various categories of goods and services.

The basket of the index has items clustered under 13 categories to cover the range of consumer spending.

Since a great proportion of income of the average Kenyan goes to food, food and non-alcoholic beverages take 32.9 percent of the index weight, which is the highest in all the categories.

So, when we interpret the consumer price index as a reflection of rising cost of living, we need to have it in mind that it only weighs 32 percent on the index.

The next question will be, since inflation is measured as a percentage of change of the price index, does 32 percent which goes to food and non-alcoholic beverages provide a better measure of inflation, looking at the fact that food inflation in urban areas is higher as compared to rural areas?

The highest category, in this case, food and non-alcoholic beverages, having a representation of 32 percent is well within range as compared to a dominating one of more than 50 percent.

With the highest category at 32 percent, that means more goods and services are able to be represented in the index and the more representation the better reflection the index has on consumer spending.

An example is India where the Reserve Bank of India uses the wholesale price index (WPI) to track inflation because in their rural CPI, food represents close to 70 percent and can rise faster than wholesale price index when there is high food inflation.

Also, WPI is able to understate market prices because it doesn’t factor in retail margins which is better than overstating.

It is important that inflation is accurately measured because most countries (including Kenya) moved to inflation-targeting monetary policy.

Inflation targeting allows for a desirable growth rate whilst allowing for sensible GDP expansion, so overstating inflation will lead to monetary response that will be counterproductive.

So, the concern about CPI not reflecting the cost of living is not the problem but rather the inflation-targeting framework.

Have we been having a better response in our inflation-targeting monetary framework?

We need to pay a great deal of attention to inflation expectation because the price of fuel has already increased and is expected to continue rising.

The Kenya shilling is also weakening against the dollar when we have a government heavily indebted from an unsustainable public debt as we head towards a general election.

For an inflation-targeting central bank, this is the time for the Central Bank of Kenya to communicate transparently and credibly about the economy, the forecast of growth and inflation expectations to make it easier to meet the inflation target.

Public confidence is key in the design of an inflation-targeting regime.