The Devil In Europe’s HICP
EU wide inflation rose markedly higher in January 2021, from 0.3% to 1.2% YoY. Unfortunately, this wasn’t due to a massive expansion of the economy between the end of 2020 and beginning of 2021. Instead it was down to a re-weighting of index components in the HICP (Harmonised Index of Consumer Prices).
These changes were made in response to Covid changing consumption patterns. Such re-weightings are not new, and are done periodically to create a basket of prices that better reflect what people are actually spending on. Of course, when revised in this way, the HICP stays relevant as an indicator measuring price changes. In other words, it is an important and necessary exercise.
Unfortunately, the re-weighting, while desirable, comes with drawbacks. That is, inflation data that we get for 2021 cannot be reliably and directly compared to 2020. Consider the large spike in HICP in Jan ‘21 vs Dec ‘20. We know that the gain in the index is due to a re-weighting, and not to any kind of surge in the general level of demand for goods and services. As such, the HICP cannot be compared with previous years readings in any meaningful way.
Moreover, re-weighting the HICP to reflect the evolution of consumer spending because of Covid means that more emphasis is placed on goods and services that are being purchased. The flip side to this is that goods and services that are not being purchased no longer have the same weight. Consequently, disinflationary and/or outright deflationary forces will not be reflected in the updated HICP.
The result of this is that the 2021 HICP, as an indicator of inflation, no longer provides the same level of insight into the health of the economy as it once did. For example, packaged holidays were re-weighted lower in 2021 as spending on them declined. While this makes sense from the perspective of maintaining statistical relevance, it reduces the indicator’s sensitivity to negative economic effects.
This means that someone looking at the HICP in 2021 cannot make a good judgment on the balance of inflationary versus deflationary forces in the economy. Using the same example, less money being spent on packaged holidays is a symptom of trying economic times. After all, the natural consequence of less income security is less discretionary spending.
In turn, less discretionary spending leads to less money spent on stuff like packaged holidays. The subsequent fall in packaged holiday prices therefore indicates economic trouble experienced by consumers, even if the re-weighted HICP does not. Hence, while lowered spending on such discretionary items might not be desirable for the calculation of HICP for statistical purposes, it is very relevant to people seeking to understand how economic conditions are reflected in consumer prices.
However, it isn’t all bad news. The HICP can still be used as a kind of indicator for the efficacy of monetary policy. In order to do this, the key is not to focus on individual data points and their YoY comparisons, but on the overall trend. The trend will still reveal whether ECB monetary policies are working (using the Eurozone HICP,not the EU HICP as shown above), especially since their monetary policies are implemented over protracted periods of time.
The re-weighting of the HICP underscores the importance of knowing how the compilation of economic statistics evolve over time, and how that evolution impacts our interpretation of them. At the end of the day, the HICP is, on its own, a statistical exercise, and has to evolve to remain fit for that purpose. Users of the data simply have to adapt accordingly.
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