Measuring inflation

Introduction

The Cost of Living

The cost of living is a measure of changes in the average cost for a household of buying a basket of different goods and services

In the UK there are two measures, the Retail Price Index (RPI) and the Consumer Price Index (CPI)

Price data is used in many ways by the government, businesses, and society in general. They can affect interest rates, tax allowances, wages, state benefits, pensions, maintenance payments and many other 'index-linked' contracts.

CPI Inflation

The consumer price index (CPI) is a weighted price index, which measures the monthly change in the prices of over 600 different goods and services

The weights are revised each year, using information from the Family Expenditure Survey. The expenditure of the highest income households, and of pensioner households dependent on state pensions, is excluded.

Calculating a weighted price index

Category	Price Index	Weighting	Price x Weight
Food	104	19	1976
Alcohol & Tobacco	110	5	550
Clothing	96	12	1152
Transport	108	14	1512
Housing	106	23	2438
Leisure Services	102	9	918
Household Goods	95	10	950
Other Items	114	8	912
		100	10408

Weights are attached to each category and then we multiply these weights to the price index for each item of spending for a given year.

• The price index for this year is: the sum of (price x weight) / sum of the weights
• So the price index for this year is 104.1 (rounding to one decimal place)

The rate of inflation is the % change in the price index from one year to another. So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the annual rate of inflation = (112.5 – 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%.

The UK Inflation Target

Since 2004, the inflation target for the UK has been consumer price inflation of 2.0%

This target is set each year by the Chancellor and it is the task of the Bank of England to meet this target. There is a permitted band of fluctuation of +/- 1%.

In the early years of this decade inflation stayed comfortably within target range but this changed from 2007 onwards. The target was breached for the first time in the spring of 2007 when inflation edged over 3% before falling back. But in 2008 there was a renewed surge in consumer prices that caused CPI inflation to spike up above 5%. And, despite a dip in inflation brought about by falling interest rates and the recession, CPI inflation has remained above target through most of 2010 and 2011 – averaging around 3%.

The government has not made any official change to the inflation target but, as far as monetary policy is concerned, the Bank of England has interpreted the inflation objective flexibly given the highly uncertain economic situation at home and in the global economy. They appear to have been prepared to tolerate a higher rate of inflation as the economy has struggled to emerge from the downturn.

Criticisms of the inflation target

Setting inflation targets came into fashion in the early 1990s. Macroeconomic policymakers were looking for a way of introducing transparency and credibility into monetary and fiscal policy by having a clear final target or objective – namely price stability at a low (positive) rate of inflation.

The hope was that an inflation target would provide an anchor for inflation expectations, giving businesses and employees the confidence that the purchasing power of money would be protected and encouraging long term planning and higher levels of investment.

Whilst inflation targets seemed to work well during a period of global macroeconomic stability, the inflexible nature of targets has come under growing criticism in the last few years.

In respect of the UK, one criticism has been that the chosen inflation measure and target (CPI inflation of 2%) was not designed to deal with inflation shocks from abroad which, in themselves were not the result of whether UK policy interest rates were at the right level. 

A few years back when many businesses were outsourcing and off shoring and China and other emerging markets were making big inroads into world trade, there was a collapse in the price of manufactured goods from DVD players to freezers, kettles and iPods. This led to a fall in consumer prices fell relative to wages and profits boosting people’s spending power. One city economist talked about the“real product wage” – i.e. what goods and services could be bought with £100 of wage income.

This heralded a period when official CPI inflation was below the 2% target; indeed policy-makers focussed their attention on preventing price deflation. To prevent this from happening required a boost to domestic spending through a combination of lower interest rates and an expansionary fiscal policy. Cheaper interest rates encouraged consumer borrowing and also acted as a stimulant to the UK property market. In the short term this boosted AD and GDP growth but at the expense of causing big imbalances – shown by a falling savings ratio, huge levels of personal sector debt, and an unsustainable housing boom.

Fast forward to 2006-08 when booming emerging market countries were contributing to a sudden and sharp rise in world commodity prices, leading to a burst of cost-push inflationary pressures in the UK. This time, CPI inflation surged above the target but once more for reasons that were not to do with what was happening domestically – inflation was being driven by external rather than home-grown headwinds. The response of the Bank of England was to ‘tighten’ policy by raising interest rates and this did much to bring down the housing market.

Thus some economists believe that a narrow inflation-targeting framework has introduced a "stop-go" element into the British economy that has made our cycle more volatile.

Limitations of the Consumer Price Index as a measure of inflation

The CPI is a thorough indicator of consumer price inflation for the British economy but there are some weaknesses in its usefulness for some groups of people. This has become an important issue both when CPI inflation has been well above target.

1. The CPI is not fully representative: Since the CPI represents the expenditure of the ‘average’ household, it will be inaccurate for the ‘non-typical’ household, for example, and 14% of the index is devoted to motoring expenses - inapplicable for non-car owners. We all have our own ‘weighting’ for goods and services that does not coincide with that assigned for the consumer price index.
2. Housing costs: The ‘housing’ category of the CPI records changes in the costs of rents, property and insurance, repairs and accounts for around 16% of the index. Housing costs vary from person to person, from the young house buyer, to the older householder who may have paid off the mortgage.
3. Changing quality of goods and services: Although the price of a good or service may rise, this may be accompanied by an improvement in quality. It is hard to make price comparisons of electrical goods because new AV equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.

One of the big issues in recent times has been the difference in measured inflation between the Consumer Price Index (CPI) and the Retail Price Index (RPI). The latter includes mortgage interest costs in its calculation and is therefore more sensitive to changes in the cost of mortgage borrowing.