Pantheon Macroeconomics

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22nd Feb 2021 10:45Question of the week

Question of the week: What impact will the re-weighting of the CPI have on its potential to rise this year?

A:

The annual re-weighting of the CPI will limit the ability for the headline rate of inflation to pick-up later this year in response to a surge in demand for services. The ONS largely followed its usual method of updating the weights of the components at the start of the year according to spending levels two years previously. But this time, it updated the weights using 2020 consumption data, if spending in a component rose or fell by more than 25% last year, so that the headline rate reflects the current reality better. Of the 87 components, 25 were updated for 2020 spending. 

As a result, the weights for key services components have declined significantly. Our first chart below shows that the weight for catering services has dropped to 72 per 1000, from 99 last year. Similarly, the weight for accommodation services has dropped to 14 from 20, and to 12 from 42 for package holidays. By contrast, the weights for goods that have been in high demand this year, like computers, games and household appliances, all have increased.

These weight changes won’t have much impact on the headline rate in the near term, as it is compiled from month-to-month changes in the components. Note too that the weight changes had a small upward impact on January’s headline rate, primarily because the weight for the airline fares index fell to 3 per 1000, from 5 in 2020. This meant that the big seasonal month-to-month fall in airline fares in January made a smaller negative contribution to the month-to-month change in the headline rate than in 2020.  This contributed to the rise in the headline rate to 0.7%, from 0.5% in December.

Nonetheless, the dominant impact of the weight changes will be to prevent CPI inflation rising this year in response to any rotation by consumers away from goods towards services. Renewed declines in prices for goods that recently have been in high demand will easily temper the boost to the headline rate from rising services prices. Our second chart below shows the impact on our forecast for CPI inflation of simply moving to the new weights, holding all other factors steady. This is a purely illustrative projection, as we already had partly anticipated the weight changes in our prior forecasts. It shows that CPI inflation likely will be 0.2pp lower this year than if the weights had not been changed.

These weight changes aren’t significant enough to stop the headline rate rising sharply this year in response to higher energy and food prices.  We expect CPI inflation to hit the 2% target in May, and to average 2.3% in Q4. But the core rate likely will remain comfortably below 2% once again this year, placing little pressure on the MPC to begin to warn of higher interest rates ahead.

 

 

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Keywords for: Question of the Week, WC 15th February 2021

What impact will the re-weighting of the CPI have on its potential to rise this year?,