Lies, damned lies and inflation statistics
Why 0% inflation is leaving many of us out of pocket
As inflation tumbled to a mind-numbing zero per cent earlier this week, the question on many people’s lips is: why is everything still getting more expensive?
The simple answer lies in the tired old joke about the statistician "who drowned in a pond that was only 1-inch deep – on average". The Retail Price Index, or more to the point, the Consumer Price Index, is no more than a measure of how fast the cost of an average basket of purchases has changed over a period of time, usually 12 months.
It's given by the simple formula ((Pi – Po)/Po)) x 100, where Po is the price of the basket a year ago, and Pi is the price of that basket now. If the average shopper spent £200 a month on groceries a year ago, and £204 on those same groceries now, then as far as most of us are concerned, the rate of inflation is two per cent.
(Not so economists, who would probably accept that definition of inflation on pragmatic grounds, but will continue to argue til the cows come home as to what inflation "really is").
Of course, that is only part of the story. One source of confusion is the way in which government happily bandies about two quite different statistical measures – Consumer Price Index (CPI) and Retail Price Index (RPI) – and the fact that these are now a long way apart. So whilst CPI is currently running at 3.2%, RPI is 0%.
Worse still, the newspapers are starting to report inflation measures that vary according to age or social class. It is possible to have too much information.
Let’s start with how that notional basket of prices gets put together. It is an average shopping basket supposed to represent what the average Brit spends in a month. As the Office for National Statistics (ONS) puts it (pdf): "a convenient way of thinking about the RPI is to imagine a very large ‘shopping basket’ full of goods and services on which people typically spend their money: from bread to ready-made meals, from the cost of a cinema seat to the price of a pint at the local pub, from a holiday in Spain to the cost of a bicycle".
Categories of spend included in the calculation range from necessities – such as food, utilities and cost of accommodation - through to what are usually regarded as discretionary purchases: entertainment, holidays and electronic goods.
The ONS carries out a massive monthly sampling process to track movements in each item and category. They also apply a weighting process to compensate for the extent to which one or other item features in the national shopping basket. As a nation, we spend more on petrol than bubble gum: so a small rise in the price of petrol will have a much larger effect on the indices than a massive rise in the cost of bubblegum.
Keeping consistency between these shopping baskets, year on year, is rather more difficult, and is managed through some rather clever statistical sleight of hand. Some items – such as videos and video recorders – can flit in and out of the price indices in the space of no more than a decade. Other items may gradually appear (or disappear).
This month (pdf) saw the addition of rosé wine, hot rotisserie chicken and internet-based DVD subscriptions, whilst wine boxes, MP3 players and rentals from DVD hire Shops were booted.
Many items included in the original RPI when it was launched in 1914, including candles, mangles, back-lacing corsets, tram fares and shirt collars, have dwindled or vanished altogether.
That index was created to protect workers from the 'temporary' economic consequences of the war, and its origins as a stark and ever-so-nannyish cost-of-living index can be seen in the fact that most of its indicators were food or food related. Alcohol was excluded altogether and tobacco received only a small weighting (share) of the total spend, well below the level it actually merited.
The nanny state, with its distaste for unhealthy living and anti-social purchases, is not a New Labour invention.
The CPI is much newer and was created at least in part as a means to create cross-European comparisons for prices as a precursor to monetary union. It differs from the RPI most in the areas of council tax and owner-occupier housing costs, and the fact that it is calculated as a geometric mean, rather than a simple arithmetic one. In theory, that should make the CPI a more accurate reflection of changes in what consumers spend and usually lower than the RPI.
The fact that it suddenly is much higher reflects the recent dramatic falls in interest rates: if you have loans or a mortgage, you are likely to be (much) better off. If you haven’t, then prices are heading upwards.
Unfortunately for Gordon Brown, although RPI is used to set many public policy decisions, such as state pensions, welfare benefits and index-linked government bonds, the measure that government has chosen to highlight as an indicator of its success over the last decade - and which has been used to target bank interest rates - is CPI. Just when he needs good news most, his favourite measure is turning out to be a dog.
And even the "good news" was less good than hoped, as it turned out that the actual inflation levels released this week were higher than experts had been predicting just one week ago.
As to why some of us are feeling poorer: none of us are average. If you had a high mortgage , large (variable rate) loans and lived on your own, the chances are that you would now be feeling relatively affluent: otherwise, the days of low to negative inflation to come may turn out to be pretty illusory.
But don't take our word for it: the ONS provides its own personal inflation calculator. So if you'd like to know what the current turmoil is doing to your purchasing power, just download the handy calculator provided here. ®
The original version of this article got its simple formula wrong and referred to the "Cost Price Index" instead of the "Consumer Price Index". Our thanks to the many people who spotted the errors.
"I had a 3 year tracker at base rate +0.44%. It ends on Wednesday, and I'm now offered base rate +3.59%"
On no account pay good money to get a tracker - get yourself a long-term fix (five-year plus, ten if you're sure of your circumstances) for under 5%.
Inflation will take off next year and anyone on a tracker will be taken up the jaxie when interest rates go up in tandem. Good deals will start disappearing in the summer.
Re: Government choices...
Close, but no cigar.
RPI measures mortgages -- the main cost of banks lending to you and I. The 'lever' is the interest rates that the Bank of England sets, not the rates the commercial banks set. But that does not matter.
If RPI had been used instead of CPI to set BoE's interest rates, rising inflation would cause - indirectly - rising interest rates (and so discourage lending); decreasing inflation would cause decreasing inflation (and so encourage lending). But you are grasping at a valid point here.
Back the 'lever' accusation - there /is/ a danger of oscillatory behaviour, due to the reciprocation between interest rates and inflation (through sympathetic feedback). This is a feature of many physical systems, and we can simulate this effect in the equations through use of relaxation methods -- creating a lag between spikes in inflation and their effect on interest rates.
Clearly, government policy is being decided by those who really don't understand numerical analysis.
Many years ago, when I was in primary school, we had to do a class project on the cost of living. As part of this project,we had to note down what our parents were paying for various commodities, such as bread, milk, petrol, rent/mortgage, etc. In the project the teacher talked about inflation and how things become more expensive over time. Since I found this idea fascinating, I kept keeping track of the prices of various commodities and have continued this practice to this day. The result is that I now have a comprehensive record of the prices of several commodities for every year from 1976 - 2009; that's 33 years. I also tracked wages over the same time period (1976 - 1984 wages are Dad's wages, since I didn't start working until 1985). If this exercise has taught me anything at all, it's that our standard of living (related to how much we earn against how much we have to spend to live) has seriously deteriorated over that time. So, those older folks who reckon they did it tough? Have a look at this sample from my records (South Australian prices):
Dad's wage: $108.00 per week
Bread: $0.18/loaf: 0.17% of wage
Milk: $0.15/carton: 0.14% of wage
Petrol: $0.14/litre, $6.30 to fill tank: 5.8% of wage
Mortgage: $20.00/week: 18.52% of wage (House value $24,500)
My wage: $480.00 per week
Bread: $3.50/loaf: 0.73% of wage
Milk: $2.80/carton: 0.58% of wage
Petrol: $1.22/litre, $54.90 to fill tank: 11.4% of wage
Rent: $300.00/week: 62.5% of wage* (House value $410,000)
*(I actually live in a flat that costs $100/week, but I quote the rent my neighbour is paying for his house since my parents' mortgage in 1976 was on a house, so if I could live in a house like my parents', that's what I would be paying)
So, since 1976:
Wages have increased by 4.4 times
Bread has increased by 19.4 times
Milk has increased by 18.7 times
Petrol has increased by 8.7 times
Housing (Mortgage/Rent) has increased by 15 times (House value has increased 16.7 times)
Let's average these four common expenditures out: (19.4 + 18.7 + 8.7 + 15) / 4 = 15.45, so prices have increased by 15.45 times.
Wages have increased by 4.4 times.
Thus, my buying power today is: (4.4 / 15.45) * 100 = 28.48% of what it would have been in 1976.
That means I would have been nearly 4 TIMES BETTER OFF in 1976 than I am today, or would be if I could afford to live in a house.
That's just plain fucking disgusting. Don't talk to ME about low inflation, because it's a load of bloody bollocks!