Inflation is a sustained rise in the general price level. The general price level is measured using an index such as the consumer price index (CPI). The reason for using an index is that percentage changes can be shown easily, and it makes effective comparisons possible.
Two surveys need to be undertaken. One is to collect information about what people buy, currently known as the expenditure and food survey. This involves collection information from a sample of 7,000 households in the UK using self-reported diaries of all purchases, including food eaten out. The proportion of income spent on each item is used to assign a certain weighting. For example, if 10% is spent on food, then 10% of the weighting is assigned to food.
The second survey is on prices. The price survey is undertaken by civil servants who collect data once per month about changes in the price of the 650 most commonly used goods and services in a variety of retail outlets. Because similar items can be bought in high- and low-cost shops, a selection of prices is gathered for each item, with 12,000 gather in all. These price changes are multiplied by the weights to give a price index; you can measure inflation from this by calculation the percentage change in this index over consecutive years.
Assessing the measure of inflation
Since December 2003, the UK’s government’s target for CPI inflation has ben 2% (± 1%). This means that small price rises are acceptable to the UK government. If prices rise by more than 3% (like they did last month, by 3.2%) they become a concern. But if they rise by less than 1%, or even fall, then risks of deflation and even a recession might arise.
One problem with the CPI measure is that is does not include housing costs such as mortgage payments or monthly rent. Monthly mortgage payments often form a large part of a household’s spending and are certainly a cost of living for almost 10 million households in the UK, with an average mortgage debt of £130,000. So if the CPI rises by only 2%, and inflation seems under control, a rise in interest rates means that many household will nevertheless be experiencing the effect of higher mortgage payments.
For many people, wages are linked to the rate of inflation and if the CPI measure is used, wage increases will fail to take into account a large part of income in the form of hosing costs. A more appropriate measure for wage increases is the retail price index (RPI). This is more inclusive than the CPI, but it is not as reliable for international comparisons and the statistical method of basing the data is also unique to the UK. Moreover, because the RPI includes the cost of mortgage interest repayments and these will rise when interest rates are raises, any interest rate rise implemented to tackle inflation will have a one-off effect of making inflation appear worse, which makes the policy makers look incompetent.
There are several other problems with the CPI measure:
- CPI measures only the cost of living for an average household. The top and bottom 4% income brackets are not included; nor are pensioners.
- There are sampling problems: only 57% of the households respond to the survey, and when they do respond they might not give accurate information.
- The 650 items in the basket are changed only once a year, but tastes and fashions change more quickly than this. In addition, the basket does not reflect the fact that changes in retail outlets such as BOGOF temporarily change people’s spending habits.
- For people with atypical spending habits, such as vegetarians and non-drivers, the CPI will be unrepresentative. For example, those who often buy rail tickets will experience inflation well above 2%.
- When the quality of goods changes, the measure breaks down as it is not comparing like with like. If I bough a more expensive mobile phone this year than last year, the price change might not be the result of inflation, but because I wanted an upgrade.