Policymakers continue to struggle with UK inflation, but do they really have any control over it? David Coombs, head of multi-asset investments at Rathbone Unit Trust Management, takes a look.
Measuring consumer price inflation in an economy should be relatively straightforward. Let’s take a hypothetical household and a basket, and place in it those goods and services economists believe the household purchases every month (the consumption basket).
Then, we weight those baskets according to how much this household might spend on those goods. Next, we measure the price of this basket at a set interval over a period of time and compare its value from when we first calculated it. If the value of this basket is rising over time, then it is fair to say that prices are rising, given the number of goods and services in the basket is unchanged.
Now, we broaden this exercise to include all households in the UK, whereby we change the goods in the basket to reflect changes in spending habits. Economists then measure the annual percentage change in the value of this basket to gauge how much higher or lower consumer prices are compared with a month or a year earlier.
There's 'good' and there's 'bad' inflation. So, which is the UK experiencing?
To get an even clearer picture of how inflation trends are developing, economists compare them not just across time but across countries. This allows a sense of just how high or low price levels are versus a ‘norm’.
In the UK, the two most widely used ‘baskets’ to measure consumer price levels are the Consumer Price Index (CPI) and the Retail Price Index (RPI).
These baskets comprise different goods and services. Furthermore, different methods are used to calculate each measure, which means they can give conflicting messages with regards to inflation.
Unsurprisingly, there are key differences between the RPI and the CPI. RPI, for example, includes housing costs, such as mortgage interest payments and council tax, whereas CPI does not.
The CPI index includes spending by overseas visitors in the UK, while the RPI does not. Different methods are also used to calculate the indices.
Since the CPI was launched in the 1990s, over a 12-month rolling window, the average correlation between the two baskets has been around 90%, meaning they should provide roughly the same message regarding the underlying direction of inflation.
Over the short term, however, the two baskets can give very different readings regarding the magnitude of change in consumer price levels.
For example, in early 2009, the RPI was indicating consumer prices were contracting at around 1% year–on–year, highlighting the risk of deflation and prompting quantitative easing by the Bank of England (BoE).
At the same time, CPI was indicating that consumer prices were still increasing at a rate of around 1% from a year earlier. So, which basket gives us a ‘truer’ picture of inflation in the UK?
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