Is CPI an accurate calculation of your inflation exposure?
The term inflation is often used and misunderstood. Because of media, we often use CPI and inflation interchangeably. Inflation is a price index; it’s the difference in price of buying an item or service at some point historically versus today. However, the inflation effects I experience, versus you, versus your business is very different depending on the goods and services you consume and produce.
Governmental Price indices
Here in Canada, there are two main types of price indices.
- CPI – Consumer Price Index. As this is most relevant to investors, it is more well known. This is the end cost consumers see pay for various products and services. Basically what you or I might pay at the store.
- PPI – Producer Price Index. This is the cost produces charge for various goods (typically industrial or raw materials). As it does not include taxes, it more accurately captures business costs and profits.
Let’s compare recent data of these indices. Although CPI and PPI are price indices, they are based on very
different underlying baskets of goods (and/or services) hence their indices produce vastly different results. As of March 2021, if we looked at the two indexes versus March 2020, CPI has increased by 2.2% and PPI by 10%.
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What is causing these price increases?
First, let’s take a step back and discuss how CPI is calculated and what are the components. Based on the pie chart below, the combined effects of food, shelter, and transportation is 63% of the basket. Transportation includes some of the important components of gasoline, which can be highly volatile in pricing.
The PPI basket components are very different, as shown in the pie charge below. Most components are raw materials, to be used in the manufacturing of consumer goods. We see two similar(ish) components, which are food and energy between CPI and PPI.
We have two very different indices which is no wonder the observations of the two price changes are very dissimilar. For CPI the majority of the move had been driven by energy, with energy prices up 19% (gasoline up 35%) over the last year. In fact CPI, when energy is removed, drops to 1.1%. In PPI, energy prices have also seen a substantial uptick, rising 32%. What caused this massive increase in energy prices? If we remember a year ago, energy prices hit all time lows (oil even went negative) as oversupply effects went through the market and initial lock down effects of COVID-19 took hold. Although many government officials comment these effect are transitotry, the price at the pump begs many consumers to difer.
For PPI an even larger contributor is lumber, on the strong demand for building materials, where costs have risen over 68% in the last year. We expect that to hit the building and construction industry over the next few months, which could eventually show up in the shelter components of CPI, which is currently only 2.4%.
So based on the above analysis, we know there are certainty areas that are seeing strong inflation. But these are standardized baskets; a better question is what is my true inflation exposure, for myself or my business.
Determining your own basket
Clearly, depending on what goods and services your business spends money on, your inflation profile could look vastly different. The easiest way to start creating your own basket is by looking at your income statements. Start with the expenses and look at all of the varying costs of operating your business (rent, wages, merchandise, etc). From there a current basket of goods for your expenses can be achieved.
This might sound simple enough, but there’s a big catch. Your basket weights are likely not stable over time.
Your basket may not be fixed
Often basket weights are not stable. For example, our recent experience in COVID has told us this. COVID-19 has had an interesting effect on inflation and customer consumption. As COVID hit us with shutdowns, individual consumption had substantial changes as many people stayed home and expenses such as vacations, eating out, clothing, etc have fallen off over the last year. While the basics of food and rent have played a much more important role. The following shows Stats Canada estimated adjusted weights by month for the effect of COVID 19.
Many people look at Covid, as an extreme outlier, but even geography can play a major role inside of Canada. So depending on what you spend money and where where you are located, price increaes can be vastly different. For example we looked at price of good across some major Canadian cities in the last month and found the following results.
Then there is the seasonality effect. What you buy in December versus July or in between can be vastly different too due to weather effects as well as consumer demand. So, even if you think your business’s costs are fixed and predictable your consumers’ demand may not be fixed.
For example if we compare the weights in developed countries versus emerging countries, we see a larger percentage of the basket of good spent on the basic needs of food, as opposed to a more luxury item of more expensive housing or housing related services. This can be thought of as an income effect.
Building Your Enhanced Basket
We believe it’s important to build what we call the enhanced basket for your company. It’s based on an examination of your historical expenses as well and any forecasts future expenses or expansions you might be planning. The enhanced basket looks a geographic and seasonal effects to predict future business operation costs and educate businss planning.
However, many people stop there, but it’s equally as important to look at the revenue side of the business. Remember Profit = Revenue- expense and what we really care about isn’t minimizing expenses but maximing profit. So we know what the expenses are and can predict the change in costs associated there, but the next question would be, now that I know my personal basket, how much am I subject to inflation pressure and how much of that can I push onto consumers.
The next article in our inflation series looks at this question is more detail.