Inflation numbers really are being distorted by COVID-19 spending, new research shows

If you make economic decisions based on this Wednesday's inflation data, you may not be acting in your own best interests.

New research by two of Canada's most credible analytic agencies appears to prove that critics who have complained that inflation data has been distorted by COVID-19 both here and in the U.S. actually got it right.

The concern, expressed by credible financial publications, is that the pandemic has altered the selection of things people buy while the official "basket" of goods and services has not shifted. As the Wall Street Journal reported last month, "Inflation Is Already HereFor the Stuff You Actually Want to Buy."

The research by Statistics Canada and the Bank of Canada, covering the months of March, April and May, has shown that the COVID-19 outbreak really did shift Canadian spending patterns in a way that no longer reflected the consumer price index (CPI) basket of goods, which is only adjusted every two years.

Cheap but unwanted

As pointed out in a previous column on why people often don't believe inflation data, hotel prices fell 27 per cent in July and were still included in the CPI basket. Similarly, gasoline and airfares pulled the index down, even though they had lost consumer appeal.

Like many other statistics, including those produced by the most credible sources such as Statistics Canada, no one who really understands how data is collected and processed thinks the CPI is a perfect description of reality.

But there is plenty of research that shows the official inflation rate, as calculated by various government statistical agencies, does have an impact on economic decision-making.

Luba Petersen, an economist who does actual controlled laboratory experiments on how Canadians react to inflation, saidthere is a relationship between expected price rises and the choices people make.

"Research using U.S. survey participants has shown that people change their investment strategies in response to their inflation expectations," Petersen, an associate professor at British Columbia's Simon Fraser University who has done experimental research for the Bank of Canada, said in an email.

It's possible that basing investment decisions on data that is slightly wrong could subtly skew markets where tiny shifts in sentiment can have large effects, but it's not clear how small adjustments in the official inflation rate affect Canadian consumer decisions.

"My own experiments studying people in virtual economies have shown that people will change their spending patterns in line with their inflation expectations, in that they consume more now anticipating higher prices in the future," Petersen said.

But so far in the real world, she said, the Bank of Canada's firm grip on inflation has kept expectations low and stable.

Sudden spending change

Taylor Mitchell, one of the Statistics Canada economists who did the latest research, is careful to avoid suggesting that the CPI as it is currently measured is somehow false or inaccurate.

"I wouldn't want to use the word inaccurate because the CPI does what it is intended to do very well and that is measure the change in a fixed basket of goods and services through time," she said.

The constituents of the basket are updated regularly to adapt to changing consumer preferences. For example, 35years ago, cellphones weren't on our shopping list, because they didn't exist.

However, as it is currently designed, the CPI has trouble accounting for a shift in consumer preferences where suddenly everyone in Canada stops spending on the same things at the same time, such as hotel rooms and foreign cruises.

"With the onset of the COVID-19 pandemic, it became clear fairly quickly that Canadians weren't spending money in the way they used to," Mitchell said.

In the case of things such asmovie tickets, she said, consumers couldn't buy them if they wanted to because theatres have been closed. People spent less on meals out and more on groceries for preparation at home.

So with the help of the Bank of Canada, what Mitchell and her team did was create an "adjusted CPI" to take those new spending patterns into account, altering the weighting of goods in the basket. One of the biggest differences between the two sets of data was in flights.

"There were notable declines in the prices of airfares," Mitchell said. "Airlines were offering a number of promotions to encourage people to return to travel, but those declines took on much less importance in the adjusted CPI because demand remained so much lower than compared with recent years."

Perhaps the most surprising thing was how small the difference was between the "derived" (or adjusted) figure and the way CPI is normally calculated.

Refining inflation just for you

"Calculated using derived basket weights, the headline Analytical price index was 0.2 percentage points higher in April 2020 and 0.3 percentage points higher in May 2020 compared with the official CPI," said the Statistics Canada analysis.

As Mitchell explained, the reason for that small difference was partly because while people cut back on spending on things they could not get or didn't want, that spending shifted to other goods and services.

So far there is no plan to publish the adjusted CPI along with this Wednesday's regular inflation figures.

There is also no plan to make permanent changes to the way the CPI is calculatedbecause the statisticians feel that maintaining the current format for the sake of continuity and in keeping with international conventions is more important than making the index adaptable to events as unusual as the current pandemic.

For the Bank of Canada, which releases its next Monetary Policy Report on Oct.28, having a better understanding of how we spend our money during the pandemic especially as its effects continue into the winter will help them fine-tune their reaction.

But for consumers who still have doubts about whether inflation really reflects their own experience, Mitchell and her team are constructing a further refinement.

"Statistics Canada is actually working on a tool right now that will allow users to input their own expenses and calculate their personal rate of inflation based on what they themselves consume," she said.

Something to keep you occupied if the lockdown does not end as soon as everyone hopes.

Follow Don Pittis on Twitter: @don_pittis