Inflation, inflation, inflation: you hear that everywhere these days! The reason for this is that the increase in the prices of goods and services is extreme compared to the past decades.
In September, there was an average price increase of 14.5 percent compared to a year earlier, according to Statistics Netherlands. That’s higher than what we saw even in the 1970s, which are known for periods of high inflation.
Inflation this time is driven by the extreme increase in energy prices. Gas and electricity are significantly more expensive, but food prices have also risen rapidly in recent months. The conflict between Russia and the West following the outbreak of war in Ukraine and problems in supply chains are important reasons for higher prices.
So we now know how high inflation is currently and what the causes are. But how is inflation measured? Which goods and services are included in the calculation? It’s more complicated than it sounds.
Here are six things you need to know about determining inflation.
1. Inflation as a basket of goods and services: what do you take with you?
Statistics Netherlands (CBS) measures inflation as the increase in the consumer price index (CPI) compared to a year ago. The consumer price index shows the price development for a package of goods and services that is, on average, representative of the purchases of Dutch households.
Statistics Netherlands includes 372 different categories of goods and services in its calculation. All these components have a certain weighting for the extent to which they contribute to the average price development. Examples of categories with a relatively high weight are housing, water and energy, food, beverages and tobacco.
The weightings are adjusted once a year, based on figures on the Dutch’s consumption. The more money people spend on something, the more weight it has in the consumer price index.
It probably won’t surprise you that there are several ways to calculate inflation based on a basket of goods and services. For example, Statistics Netherlands uses its own method, and there is also a European method for calculating the increase in the prices of goods and services for comparison between different countries. For this, the European statistical office Eurostat uses the HICP method harmonized index of consumer prices.
An important difference between the two methods is that the calculation of Statistics Netherlands takes into account the cost of owning a home, while the European method does not take this into account. These costs make up around 15 percent of the Dutch consumer price index.
Another important conceptual difference is that the Dutch consumer price index looks at the prices that residents of the Netherlands wages and HICP to the prices in the Netherlands. As a result, e.g. the Dutch’s spending abroad included in the consumer price index of Statistics Netherlands, but not in the HICP.
In addition, there are many other minor differences. For example, the consumer price index from Statistics Netherlands includes contributions to sports and leisure associations and social organisations, while these are not taken into account in the European method.
Motor vehicle tax and dog tax also fall outside the scope of the HICP, but they are part of the calculation method used by Statistics Netherlands.
2. How do you measure energy prices against inflation?
Statistics Netherlands is currently reviewing the calculation method used to determine the development of energy prices. The Statistics Office is expected to come up with a new method in the middle of next year, which is closer to reality.
Due to the current method of measuring energy prices, the overall average price increase of goods and services is currently rather overestimated.
This happens because Statistics Netherlands looks at the prices for energy contracts that energy suppliers offer to new customers. As many old contracts from existing customers still run at lower prices, not everyone pays the new high prices. As a result, the energy prices used by Statistics Netherlands are ahead of what households actually pay on average.
If energy prices start to fall, inflation will actually be underestimated under the current method. In that case, Statistics Holland again starts from the energy prices in the newer contracts, which fall faster compared to the prices for existing customers. The higher prices that still apply in much older contracts are not taken into account.
In short, if there are strong price fluctuations in a short time, the current measurement method for energy is not very accurate.
In the new method, Statistics Netherlands wants to include the development of the prices of long-term energy contracts. It should give a more realistic picture, as many households set energy prices for several years.
If we look back at inflation in recent months, it is lower under the new method. The preliminary investigation by Statistics Netherlands shows that inflation in August last year with the new calculation would not have been 12 percent, but between 7.5 percent and 9.6 percent.
Read Lake: NDutch inflation of less than 10%, if you are with dactual energy costs
3. Housing costs: rent and mortgage costs
How are housing costs factored into the inflation calculation? Rent increases are relatively easy to measure, and Statistics Netherlands does just that. But it is different with installments on mortgage loans. After all, everyone has different mortgages with varying fixed interest periods and the statisticians do not have an overview of that.
Therefore, Statistics Netherlands has chosen a special approach to estimate housing loan costs, the so-called imputed rent. Housing expenses are calculated as the rent that the owner could receive if he or she rented the property to someone else. It therefore corresponds to the amount that the household itself would pay if it had to rent a comparable home.
The increase in the estimated mortgage costs is therefore linked to the increase in rent. The fictitious housing costs for homeowners increase if the rent on a comparable home increases. Statistics Netherlands estimates the increase in housing costs for homeowners if the rent is adjusted in July.
CBS chief economist Peter Hein van Mulligen sees the idea of including repayments on mortgage loans as part of inflation as undesirable. “If mortgage interest rates rise, it will mean that inflation will also rise. To combat high inflation, the central bank usually raises interest rates. This in turn would mean that mortgage interest rates would rise, and so would inflation. The central bank can no longer use interest rates to push inflation in the desired direction.”
4. Wealth inflation
The consumer price curves from Statistics Netherlands and Eurostat do not take into account changes in the value of assets. For example, fluctuations in the value of investments or housing prices are not included in the inflation rate.
If that were to be taken into account, the price increase in 2022 could possibly be somewhat lower than is the case at the moment: After all, prices on the stock market have fallen considerably this year.
5. Better products at lower prices
Another complexity in determining inflation is how to account for products whose quality improves over time. This is because Statistics Netherlands assumes the same quality of products in its calculation of the increase in the prices of goods and services.
In particular, many consumer electronics such as computers, televisions, DVD players and telephones have greatly improved in quality in recent decades. They have also fallen sharply in price. For example, computers in 2009 cost only 10 percent of the price in 1996.
Statistics Netherlands sees an improvement in quality as a drop in price. How this works becomes clear in the following example.
In 2004, a popular computer with a Pentium 4 processor cost $1,000. Five years later, a comparable computer is no longer available, and a popular computer with a Core2Duo processor costs 600 euros. This is therefore a nominal price drop of 40 percent. But the new product is of higher quality. Statistics Netherlands corrects for this quality improvement by allowing the price drop to rise to 60 percent, thus pretending that the new computer only costs 400 euros.
6. Lower inflation doesn’t mean prices are falling!
The literal definition of inflation is the increase in the prices of goods and services. So when we talk about falling or lower inflation, it means that the rate at which prices are rising is slowing down…not that prices are falling! There is often confusion about this.
The above also means: if inflation is 0 percent, prices are stable.
We can take the price of petrol as an example. Suppose it rises from 1.50 euros per liter at 2 euros per liters in a year. This means an inflation of 33 percent. But if the price of petrol is at the same level a year later, inflation on an annual basis is 0 percent, while the price has remained quite high at the level of 2 euros per
We are currently probably around the peak of the current wave of inflation. This means that there is a significant chance that inflation will be lower in 2023. This does not mean falling prices, but a less sharp increase in prices. If prices actually fall, there is deflation.