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How is Inflation Measured?

 

Inflation refers to the rise in prices over time. There are different ways inflation can be measured, and since 1989, the UK’s main method of measuring annual inflation has been through the consumer prices index (CPI), which has not fell below 0% in any year since. This means that the prices of most things has risen every year. 

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The CPI represents a basket of everyday goods and services that is purchased by households. Included are items such as flour, petrol, TVs, rent and tea bags. It measures the rate at which the prices of the items within the basket rises or falls. Each item is assigned a weighting so that items which households spend more money on are represented. There are around 730 different good and services in total that are tracked, with multiple price quotations collected for each item from a variety of locations across the UK.

 

You can see the entire list of goods and services which are included by clicking here

 

The items included within the basket are constantly changing because they are supposed to reflect changes in consumer preferences. For example, meat free sausages have recently been added to the basket as more people are moving away from meat and the demand for vegetarian and vegan options increase. In addition, antibacterial wipes have been added to the basket because the demand for antibacterial products has increased off the back of the pandemic. Men's suits have been taken out of the index with a fall in usage due to the rise in home working. 

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You can see the breakdown of the different categories of household spending below along with their respective weightings. 

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Consumer Prices Index 2022 Weightings

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Source: Office for National Statistics (ONS)

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The average rise in consumer prices for the UK has been roughly 2.5% from 1989 to 2019. This is a similar case for developed nations around the world. It doesn’t matter whether its the cost of shopping, holidays, cars or houses, the prices of all these thing would have risen since you entered the world and will continue to rise throughout your lifetime. 

CPI yearly 1989-2019.png

Problems with the Consumer Prices Index (CPI)

 

Weightings

The weightings placed on each category is highly judgemental. If household A, spends 40% of their expenditure on housing, 20% on transportation, 10% on food and 30% on all other categories, while household B is much wealthier and only spends 20% of their expenditure on housing, 10% on transportation, 5% on food and 75% on all other categories combined, any change in the price of various categories will be felt differently to each household. 

 

Although the weights placed on each category are supposed to be representative of the general population, they are unlikely to reflect your exact situation, preferences and income. For example, an adult living with their parents with no kids, compared to a parent with two kids and a house will utilise their resources very differently. If the adult living at home spends proportionally more of their income on cars, clothes, electronic goods and eating out, and these things all rise in price, this will have a more noticeable impact on them than the parent with two kids. 

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Blind Spots

If a good or service is not included within the identified basket, it will not be factored into the calculation. This is because the calculation is based off a sample of goods and services produced within an economy. Therefore, it does not represent all production or consumption within an economy.

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Substitutable Goods

If the price of something rises, a number of consumers may substitute this with a similar item that is cheaper. For example, instead of buying a branded good such as Heinz Ketchup, customers may switch to an own brand Ketchup from their local supermarket. This is not accounted for. 

 

Quality Changes

There may be instances where index calculations cannot be based on "like for like" comparisons. Where the rate of technological progress is high, for example personal computers, a rise in prices could be down to faster processing speeds. Prices are adjusted to take account of quality changes however, this can be highly subjective and is prone to debate.

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Retail Prices Index

The retail prices index (RPI) was first calculated in June 1947, but is no longer considered an official inflation rate by the government. CPI is the inflation measure used in the government’s target for inflation.

 

The RPI includes things such as mortgage interest costs and house prices, which the CPI does not include. Including mortgage interest payments does not necessarily capture the cost of consumption, but rather how the consumption of goods and services is financed. Including house prices captures changes in asset values rather than focusing on the cost to consumers of actually renting a home. This means that the RPI is heavily influenced by house prices, which the CPI is not. 

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The RPI uses the Carli and Dutot formulae to calculate inflation, which is different to CPI that uses the Jevons formulae. In 2015, there was an independent review of UK Consumer Price Statistics by Paul Johnson. The review concludes that "Carli should not be used in any index aiming to achieve a good estimate of changes in consumer prices" and further that it "is not suitable for use".

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When compared to the CPI the RPI often overstates inflation. This is the reason why companies such as Vodafone use it when calculating annual price rises. Interest on student loans is also linked to the RPI (I wonder why...). 

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The Office for National Statistics even states that "RPI is a very poor measure of general inflation, at times greatly overestimating and at other times underestimating changes in prices and how these changes are experienced". This is the reason why in 2018 the former Bank of England Governor Mark Carney wanted to scrap the use of the RPI being linked to future contracts. 

 

Despite this, it is useful in the sense that it stretches back further than the CPI to get a rough understanding of how inflation moved in the past. 

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RPI yearly 1949-2019.png

Source: Office for National Statistics (ONS)

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Between 1949 and 2019 (70 years) there has been only one year in which the annual rate of inflation as measured by the RPI was negative, which was in 2009. Over this period the average annual inflation rate was a staggering 5.3%.

 

If the price of a house in 1949 was £10,000 and rose in price every year by 5.3% how much would it be worth after 70 years? 

 

The price of the house would be £371,523 in 2019 (an increase of almost 40 times it's initial value).

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