Inflation - The Basics

Inflation - The Basics

Inflation is defined as a sustained rise in the general price level. This is a very general definition. When the 'inflation figures' come out once a month and are quoted on the news, the newsreaders give certain percentage 'rates of inflation'. These are annual percentage changes in certain indices. The Retail Price Index (RPI) is the most famous, but the government prefer to quote the RPIX for reasons that will soon be explained. There are other, less quoted, measures that need to be considered too.

The Retail Price Index (RPI)

This was virtually the only measure available until the early 80s. The index has no units. It is just a set of numbers that show the monthly change in the (weighted) average of a 'basket' of goods and services. The choice of goods and services that make up this 'basket' has to reflect a typical household. There is an annual Family Expenditure Survey that is used to find which goods and services to include in the 'basket' and which are the most important. Housing and food costs, for example, will be more important (because they make up a larger proportion of a typical household's monthly expenditure) than, say, tobacco.

The inflation figure that you hear on the news, therefore, is the annual percentage change in this index, from the most recent month compared with the same month in the previous year. It is often referred to as the headline rate of inflation. See the next section for a numerical example of how this is calculated.

RPIX

The 'X' doesn't actually mean anything. It's just a label, a bit like the x-axis and the y-axis in maths. The inflation rate calculated from the RPIX is often called the underlying rate of inflation.

This is exactly the same as the RPI except that one of the items in the 'basket' of goods and services is taken out. This item is mortgage interest payments. Although this is a very important part of most households' monthly expenditure, the government prefer to quote inflation as the annual change in RPIX. The reason for this is the link between the main instrument used to control inflation (for example, interest rates) and the RPI itself.

When it is felt that future inflation will rise above the government target, the Monetary Policy Committee (MPC) will raise interest rates to reduce aggregate demand and dampen inflationary pressures. The problem is that raising interest rates directly affects the RPI (through higher mortgage interest), so the instrument that is being used to control inflation affects the inflation rate itself! This is a bit self-defeating! This is why the government prefer to target inflation based on the RPIX, because the mortgage interest payments are excluded.

RPIY

This measure takes the RPIX one stage further. This is the same as the RPIX, but excludes indirect taxes as well. Again, the items that have been eliminated are things that the government can directly change. An increase in fuel duties, for example, will cause the rate of inflation to rise instantly. This rise may have been part of a policy on the environment, so some believe that it should not be reflected in the rate of inflation. Others argue that rises in indirect taxes cause the price of a large proportion of the goods and services that people buy to increase. If an 'inflation rate', however it is measured, is meant to reflect rises in the cost of living, then it is a bit silly to take lots of factors out of the measurement.

Probably for this reason, this is a less quoted statistic than the other two measures, even though the inflation rate based on this index tends to be much lower.

The Harmonised Indicies of Consumer Prices (HICP)

This is a measure that is used across the EU so that fair comparisons of inflation rates across countries can be made. Using this measure, the UK had the lowest inflation rate in the EU (at 1.1%) for much of the year 2000.

As was mentioned earlier, the RPI is an index and is calculated as a weighted average. The 'weights' are designed to allow for the relative importance of the different goods and services within the simple average. The table below gives the weights, in terms of percentages, of the various goods and services for 1998.

Item: Weight (%):
Housing 20
Motoring expenditure 14
Food 13
Leisure goods and services 11
Alcoholic drinks 7
Clothing and footwear 6
Fuel and light 4
Tobacco 3
Others 22
Total: 100

These figures are rounded to the nearest percent. 'Others' includes households goods and services, personal goods and services and other, non-motoring, travel costs. The most notable changes in the weights over the last decade have been the fall in the importance of food relative to housing, motoring and leisure.

Every month, a carefully selected sample of outlets is used to find the price of the numerous goods and services included in the index. 150,000 prices are collected for 600 items. Obviously the prices will vary, especially between regions. An average price is then calculated for each item. All these averages are then multiplied by their respective weights, and then the grand total is divided by the total number of goods and services in the basket. This gives you the weighted average.

This information now has to be converted into the index. All index series have a base year, or in this case, a base month, which is given the value 100. There are no units. The purpose of the index is to reflect the relative changes in the weighted average; units are not important. If the RPI started in January 2000, and the weighted average calculated in February rose by 4% when the figures were collected, then the value of the index in February would have been 104.

So how is the inflation rate now calculated?

Using the real figures, the RPI was 170.5 in July 2000, the figure for July 1999 was 165.1, and so we now simply work out the percentage change:

So, the inflation rate for July 2000 = 3.3% (correct to one decimal place)

Note that whilst the figure for inflation is 3.3%, this is only an average. In recent years, the price of electrical goods and computers has fallen (a negative inflation figure), but the price of things like beer, petrol and water have risen by more than 100%!

Finally, any inflation measure does not allow for changes in the quality of the goods and services. Computers, for example, never really seem to get that much cheaper. What tends to happen is that the price remains roughly the same, but you get more for your money. A £1000 computer bought a 200Hz processor a few years ago, a 400Hz processor a year ago and a 700Hz processor today (this may have changed by the time you read this!).

A historical prospective

A historical prospective

The diagram above is a sketch of the path of the inflation rate since the mid 50s. Note that it is only a sketch, showing the broad trend rather than every single small change.

The inflation rate (based on the RPI) has had a roller coaster ride since the war. Once the problems of rationing were out of the way in the mid 50s, the inflation rate stayed at or below 5% until the late 60s. Problems with the unions in the early 70s caused the rate to rise to 10%, and then the oil price shock of the mid 70s (quadrupling of the price of oil) caused the rate to peak at 27%! There was a second oil shock in the early 80s (a doubling of the price) taking the inflation rate back up to 20%.

After this event, the new Conservative government made inflation the number one enemy. Monetary targets, high interest rates and (attempted) control of government spending finally caused inflation to fall back below 5%, although at the cost of over 3 million unemployed.

The boom of the late 80s created inflationary pressures, and, although the UK economy was now better equipped to deal with them, inflation rose to 10%. The subsequent rise in interest rates to 15% caused a painful recession. The discipline of the Exchange Rate Mechanism (ERM) helped to get inflation down, as did the fact that the exchange rate was too high in the system. The money fell out of the ERM, devaluing by 15%.

Many felt that the drop in the £ and the resulting rise in the prices of imports would cause prices, and interest rates, to rise again. But the structure of the economy had changed. The supply side reforms of the 80s had improved the productive potential of the economy, and consumers were much more price sensitive following the recession of the early 90s. Firms' costs may have been rising due to increased import prices, but the consumers were simply not prepared to pay higher prices in the shops. They would 'shop around'. Inflation has now been below 3% for over 5 years. Many believe that the improvement in the conduct of monetary policy since the ERM debacle has been a major factor (see the Learn-It called 'UK monetary policy').

An international perspective

Whilst other countries suffered from the same oil price shocks, somehow they always seemed to deal with them better than the UK. The fact that the value of the £ has been on a downward long term trend for over 100 years fully reflects the fact that the inflation rate of the UK tends to be higher than that of other countries.

Throughout the 70s, the UK had the worst record on inflation of virtually all developed countries. Even in the 80s, when UK inflation dropped below 5%, other countries managed lower rates. Things are beginning to turn round though. As explained above, the inflation rate has been below 3% in the UK for 5 years now, and recent published HIPC figures show that, finally, the UK has one of the lowest, if not the lowest, inflation rates in Europe. The newish structure of UK monetary policy has been praised by most economists. It has credibility, the most important thing in today's capital and foreign exchange markets, and looks to have a lid on inflation for the foreseeable future. See the Learn-It called 'UK monetary policy' for more detail.

Update: The Inflation Rate in the United Kingdom averaged 2.73 percent from 1989 until 2015. The peak was an all time high of 8.50 percent in April of 1991 and a record low of 0 percent in February of 2015

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