Why does inflation matter
It matters to investors and savers because when inflation is high, it quickly erodes the true value of investments and savings, and it matters to borrowers because it reduces the real value of their debt. If inflation is rising at 5% a year, but your investments are growing in value at only 4%, the purchasing power of your money will be falling at 1% a year – ie, while your money appears to be growing in ‘nominal terms’, it is losing value in ‘real terms’.
But inflation isn’t a problem, is it?
On the face of it, not really. It’s been 24 years since inflation was last in double figures and, from 1997, when Labour came to power, to this summer, official numbers have put inflation as measured by the Government’s preferred measure, the Consumer Price Index (CPI), at under 2%. This is in part down to the fact that the Bank of England, which is supposed to set interest rates independently of the Government, has a policy of ‘inflation targeting’. This means that it is obliged (by the Government, which sets the target) to keep inflation as near as possible to 2% and that it therefore operates monetary policy (interest-rate decisions) in such a way as to ensure this. Our seemingly low inflation is also due to the fact that the last decade has seen an era of low global inflation, thanks to the rise of manufacturing in low-cost economies, such as China.
So what is there to worry about?
Not only have the official figures started to exceed 2% (the CPI is now running at 2.3%, its highest level since it was introduced in 1997), but there is a growing body of opinion that says that the numbers used by the Bank of England heavily understate the level of inflation suffered by the average consumer. In December 2003, Gordon Brown switched the Bank’s inflation target from the long-standing Retail Price Index (RPI) to the CPI. Handily, the CPI, unlike the RPI, excludes the rising price of houses. Instead, it includes a housing component based on theoretical “owner’s equivalent rent” (OER) figures that diverge enormously from actual house prices. The Government comes up with this figure by sampling the price of rents in residential housing to arrive at what a homeowner would notionally receive if they were to let out their own home. But most people don’t do that: they live in their houses paying mortgage payments, property taxes, utility bills and for all kinds of other repairs and services (the costs of all of which are rising fast). Yet the OER figure makes up 23% of the Consumer Price Index. Critics see this as just one of the ways in which the reported rate of inflation is being kept artificially low.
How else is it kept artificially low?
There are a variety of ways in which the headline rate of inflation is kept in check. First, when inflation is rising, the Bureau of Labour Statistics (BLS) tends to quote the “core rate” of inflation, stripping out food and energy costs, as though the rising oil price were a one-off factor, rather than an integral part of the economic story. Second, the BLS uses the principle of ‘substitution’ in its calculations – taking out items that are getting more expensive (eg, beef) on the grounds that people will buy cheaper alternatives instead (eg, chicken). Third, they use ‘hedonics’ – the controversial practice of adjusting the real price of goods according to the increased ‘pleasure’ a consumer is thought to derive from them. For example, a new TV might cost the same as the one you bought last year, but if the new one has a flat screen, it is considered to be ‘worth’ more and the Government statisticians (both in the US and here) will count it as a price fall, since it’s higher quality. Similar statistical sleights of hand are used in the US, where inflation also seems lowish at 3.2%, but where prices of most services (education, healthcare, insurance, etc) are soaring.
Why does all this matter?
Because the official rate of inflation dictates interest rate policy. And if the inflation statistics are being kept artificially low – thanks to moving targets and ever-more complex calculation methods – it means the Bank Of England is, in effect, being encouraged to keep interest rates artificially low, as is the Federal Reserve in the US. This has the power to distort the economy as a whole: if money is cheaper than it should be, people will borrow more than they should and that excess liquidity can end up encouraging inefficient investment and asset bubbles. In the UK and the US, interest rates have been very low for a long time. This state of affairs is one that many now say – and even Alan Greenspan alluded to it in his retirement speech last week (see page three) – has been the primary cause of the recent extraordinary rise in consumer debt, in the levels of risk investors seem to be prepared to take, and of the housing bubbles that are now threatening to burst.
The rocketing price of services
Even though the price of goods has been falling since 1997 (televisions and computers have halved in price; shoes and clothes are down by a third), the cost of services, which are less affected by international price pressures, are up 29%, far above the ‘official’ rate of inflation. Better-off families in particular have reason to suspect that their money is not going as far as it once did. Since 1997, the cost of private education is up nearly 50% and the price of a typical holiday is up 40%. Home insurance is up 12% and car insurance has rocketed 77%. Petrol costs a third more, and the average Band D council tax bill is up a massive 70%.