Time to think again about the way we measure inflation?

As was widely expected, annual inflation increased again last month; there is, however, a big question over how accurately these figures capture the extent of the price increases in different households.

Matthew Whittaker is a senior economist at the Resolution Foundation

As was widely expected, annual inflation increased again last month. A combination of the VAT rise and higher oil prices helped push CPI from 3.7% in December to 4% in January – twice the government’s official target of 2 per cent. The wider RPI measure also increased, from 4.8% to 5.1%.

There is, however, a big question over how accurately these figures capture the extent of the price increases in different households.

As reported by Larry Elliot and Simon Briscoe, some statisticians are concerned that official measures of inflation understate real trends in the cost of living being faced by consumers.

The problem goes beyond the government’s decision to shift benefit-indexing from the RPI to the lower CPI measure. It raises wider questions about how and why we’ve settled on these particular definitions of inflation in the first place. Our analysis at the Resolution Foundation shows that headline inflation figures fail to capture differences in spending habits – and therefore price increases – across different household types.

In recent years, rapid increases in the costs of staple goods such as food and fuel mean that the difference between the inflation faced by those in the upper half of the income distribution (higher earners) and those living in low-to-middle income households has grown. This reflects the fact that food and fuel account for a larger share of expenditure in lower income households, so when prices in these commodities rise, these households are hit particularly hard.

The chart below captures the cumulative impact of these varying spending habits on the purchasing power of different households over time:

Annual-cash-difference-in-cost-of-low-to-middle-earner-household-basket-under-different-cumulative-inflation-scenarios-02-11
From 2000-2006, the impact was fairly trivial: sometimes inflation was higher for low-to-middle earners, and sometimes it was lower – the cumulative impact on their spending power over time was negligible.

But since 2006, a solid gap has opened up in the impact of inflation on low-to-middle earners versus higher earners. Today, if low-to-middle earners had faced the same level of inflation as higher earners in the period since 2000, their typical annual basket of goods would cost about £155 less than it currently does. This is lower than the peak difference of around £300 reached in 2009, but it is still much bigger than the variation in inflation’s impact we saw in the first half of the last decade.

This all matters because government income-support mechanisms like tax credits are indexed to headline levels of inflation. As a result annual increases in payments are unlikely to have kept pace with real rises in the cost of living being experienced in low-to-middle earner households in recent years. The shift to the lower CPI measure from April will only make this situation worse.

And of course, the resultant squeeze on low-to-middle earner’s living standards is compounded by the fact real wages have been falling in the past year – average annual earnings growth stood at just 2.4% in November – and are expected to continue to decline until 2013.

For all the anxiety about headline inflation figures that will be voiced in tomorrow’s papers, the reality is likely to be worse for those on low and middle incomes.

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13 Responses to “Time to think again about the way we measure inflation?”

  1. Heidi Joluni

    RT @leftfootfwd: Time to think again about the way we measure inflation? http://bit.ly/gF5H97

  2. reded

    People complain about rising food prices but that won’t stop spending on Bollinger and caviar in the city this year.

  3. downinjamaica

    RT @leftfootfwd: Time to think again about the way we measure inflation? http://bit.ly/gF5H97

  4. Mike Thomas

    This inflation is hurting people on lower incomes because this inflation is concentrated on raw materials and foods.

    Why?

    Because some bright spark debased the currency by injecting 20% GDP through QE into the economy to prop up government spending.

    The pound has collapsed in value as a result making our imports more expensive.

    Thank you Gordon Brown and Alastair Darling.

    There was never a deflationary threat just a reckless and deliberate act for which we now have little to no control over.

  5. Dirk Wolbers

    Time to think again about the way we measure inflation? http://bit.ly/i9u1vA

  6. Red Rag

    Last months excuse was snow, this months excuse is world prices…..wonder what next months excuse will be?

    http://redrag1.blogspot.com/2011/02/red-rag-holes-in-osbornes-plans-are.html

  7. scandalousbill

    Mike Thomas,

    You Blather on,

    “This inflation is hurting people on lower incomes because this inflation is concentrated on raw materials and foods.

    Why?

    Because some bright spark debased the currency by injecting 20% GDP through QE into the economy to prop up government spending.”

    So, the Global recession and the bailing out of the banks, let alone that QE was in the mainstream the purchase of Toxic assets predicated by the former, had absolutely nothing whatsoever with the problem. Right? It was just Brown and Darling on some super shopping spending spree? How deep an observation, how astute!

    I take back my former suggestions that you read more. The only question I have based upon your comments on this and other postings is this, can you read these articles without moving your lips?

  8. Mike Thomas

    @scandalousbill.

    QE was the purchase of government bonds by banks in exchange for electronically created money. The Bank of England then lent that money to the banks. In other words, the Bank of England created funny money, bought government debt as collateral and sold that to the banks.

    In other words, the government socialised its debts and its failing into the banks as a means to provide ‘liquidity’.

    It was not and was never a purchase of toxic bank debts, 99% of QE was used to buy government debt. Not one single bank was made by the government to open its books, not even Northern Rock.

    Get your facts right first.

    The main inflator in the economy is a 9% GDP inflator because of a 25% depreciation of the pound as a result of QE. There was never, ever, any threat of deflation with that kind of depreciation. Deflation was the political cover story for increasing the money supply by 20% GDP.

    Lastly @redrag. Look at the international price of oil, gold, copper, wheat, cotton – they have all gone through the roof as commodities due to economies around the world recovering and we have a double whammy because Laurel and Hardy debased Sterling by ‘printing’ money.

    Currently raw material prices are up 15% in a year and factory gate prices are up 5% on the back of a flat to falling currency.

    There’s the source of our extra inflation, it is imported or in your fantasy world can we do without food, oil and raw materials?

  9. scandalousbill

    Mike Thomas,

    When you drop the venom and cat calls you can make intelligent comment.

    You say with regard to QE:

    “It was not and was never a purchase of toxic bank debts, 99% of QE was used to buy government debt.”

    I think we are talking first hand vs. second hand acquisition in this case. In other words, I cannot see how massive equity purchases of seriously devalued assets, whose value further deteriorated and whose deteriorated state still persists after initial purchase, cannot be considered toxic. In combination with lines or credit extended and depositor guarantees, the impacts of global factors, such as hedge fund activity in the energy sector and considerable equity shorting to me were triggers of currency pressure.
    Simply you take the supply side notion of QE as trigger; I see it more as an attempted mediation effort. For your position to hold true, it seems to me that the case should be made that currency devaluation would not have occurred otherwise. I think you will agree that most economists have assessed the recession as globally induced as opposed to country specific factors.

    Would the change of policy advocated by the Tory opposition have provided an effective alternative? If you view their position in a historical context, the situation of the 1930’s depression would suggest not. Some would say that it would have made things worse.

  10. Kyle Grayson

    Measures of inflation in the UK need to be disaggregated based on income: http://bit.ly/f8tYVu

  11. Liz Sutherland

    RT @chasing_dragons: Measures of inflation in the UK need to be disaggregated based on income: http://bit.ly/f8tYVu

  12. Mike Thomas

    @scandalousbill.

    No. Inflation is always a monetary phenomona.

    If Sterling was at its 2007 levels, the inflation we are experiencing now would simply not be happening. If you pump 20% GDP of money into an economy, what do you think the effect is?

    If you increase the supply of something, you decrease the demand of it. The price of that said thing will fall.

    In your wildest dreams can Hedge funds etc, etc perform this kind of market manipulation on such a medium term basis. Only Governments can.

    QE is not by any means, a supply side measure. It is a never-tried experiment of preventing a Keynesian liquidity trap that once interest rates hit 0%, the supply of money cannot be controlled. An argument that was never proven and never realised.

    Do you understand that? A never-tried experiment.

    Any monetarist will tell you what happens when you increase the money supply like this – inflation.

    As for commodity prices, more Chinese want to eat meat, you need to feed livestock grain for meat as well as eat it in bread or noodles. More people want Chinese electronic goods, you need copper for circuit boards. More Chinese people want to buy a car, you need oil to make cars and run cars.

    Do you see where I am going with this?

    You cannot simply open a new copper mine at the speed the Chinese can take orders for more electronic goods.

    If you increase the demand for something, yet the supply cannot rise. The price demanded will rise.

    So we are buying lots of Chinese goods, whose prices have risen, with a currency that is devalued. That’s imported inflation, on raw materials, on finished goods.

    For our own manufactured, the raw material costs have risen, our exports become less competitive too.

    China is the largest inward investor into Africa. For all of the West’s fine words and the EU trade tariffs, the Chinese are helping to build new mines, find more natural resources. In the meantime, it will use its massive foriegn currency reserves to buy all the materials it needs.

    Foreign currency reserves held in pounds, dollars, euros. If you increase the number of pounds, what do you think the Chinese will do?

    Sell their pounds and drive the price lower.

    QE is not a supply side measure, it’s economic poison that leeches into a system and distorts it for years to come.

    Labour’s QE has released the inflation genie out of the bottle, it’ll take a decade to tame it.

  13. scandalousbill

    Mike Thomas,

    You say:

    “No. Inflation is always a monetary phenomona….”

    “QE is not by any means, a supply side measure. It is a never-tried experiment of preventing a Keynesian liquidity trap that once interest rates hit 0%, the supply of money cannot be controlled. An argument that was never proven and never realised.”

    I think this approach confuses the observance of a phenomenon with its cause. Were the issues created by QE a result of, as you say: “If you increase the supply of something, you decrease the demand of it. The price of that said thing will fall.” Another position would relate to the lack of control over where and how the funds were applied.

    The example of the failed experiment of Weimar Republic in the 1920s contradicts your assertion. It was criticized by numerous economic theorists from all viewpoints from Keynes to Friedman. You may find this article by Nial Ferguson from Harvard of interest with this regard.
    http://www.martinfrost.ws/htmlfiles/nov2006/friedman_inflation.html

    So much for a never tried experiment.

    While I don’t buy all of Ferguson’s arguments, he does make an interesting point. The disassociation of monetary expansion and higher prices

    “In our time, unlike in the 1970s, oil price pressures have been countered by the entry of low-cost Asian labour into the global workforce. Not only are the things Asians make cheap and getting cheaper, competition from Asia also means that Western labour has lost the bargaining power it had 30 years ago. Stuff is cheap. Wages are pretty flat.

    As a result, monetary expansion in our time does not translate into significantly higher prices in shopping malls. We don’t expect it to. Rather, it translates into significantly higher prices for capital assets, particularly real estate and equities. The people who find it easiest to borrow money these days are hedge funds and private equity firms. Through leveraged buy outs, the latter can easily acquire companies and, by improving their cashflow, boost their valuations.”

    This brings us to your outline of an economic model. The model you propose is at best, well out of date. It is limited in application to world events. For example using the model you outlined, how would you explain the Japanese deflation of the lost decade of the late 1990s ? No demand for goods and services? No one was hungry? Hardly. Liquidity trap, possibly.

    The problem with your model is that it fails to distinguish between asset prices and consumer prices and also implies a global homogeneity in wage rates, commodity production costing and marketing that simply does not exist. The massive shift to the so called emerging nations has been fostered largely by lower wage rates and lessened corporate liabilities for poor working conditions, pollution, etc. as opposed to currency gains.

    Similarly, the US/China currency wars were not the result of QE, they preceded it. It was not simply a case of investment, due to an oversupply in one region migrating to another. I will give you that in the case of the US QE experience, the buying up of these currencies by the banks, did exacerbate a critical situation. However, I would also add that the short term growth of UK GDP of 2010, was stimulated by the increased liquidity engender by this stimulus.

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