Recent news tells us that the Bank of England has become less worried about inflation and more worried about economic growth. However, we continue to see signs of inflation, especially in the supermarket and at the petrol station. This raises the question of whether the Bank of England is using an adequate measure of inflation by tying its inflation target to the Consumer Price Index. To kickstart Inflation Focus on Morningstar.co.uk, we take at what goes into CPI and how effectively it captures inflation.
It's no wonder that inflation has been a hot topic lately. Not only are annual headline CPI figures twice as high as the Bank of England’s inflation target, the cost of food and transport has been increasing twice as fast as the headline CPI. So is CPI an accurate reflection of changes in the cost of living? To make that assessment, it's worthwhile to understand what goes into the CPI calculation as well as some important caveats that go along with this commonly cited inflationary measure.
The Basics of 'Headline CPI'
The Office of National Statistics publishes myriad statistics on inflation, but the most widely reported measure of inflation is the Consumer Price Index. This is the figure used to index benefits, tax credits and public service pensions. The Bank of England’s inflation target is also set with reference to the annual change in CPI.
CPI measures the month-on-month change for a basket of goods containing a total of 560 items from 12 different categories, such as food and non-alcoholic beverages, clothing and footwear or communications. What goes into the basket of goods is the product of an annual review process that seeks to ensure the content of the basket reflects the monthly consumption of the average British household as well as the average visitor to the U.K. That’s why items in different categories are weighted. For example, transport costs take up twice as much “space” in the basket of goods as do furniture and household related items.
For more information on how the market basket is determined, the goods and services that the CPI covers, and the process by which the ONS collects and reviews prices, click here.
Headline CPI Versus Core CPI
CPI, also known as the headline rate of inflation, is the most widely cited measure of inflation. But it can also be a volatile measure. This is why economists often cite core CPI, which excludes food and energy costs, when discussing the "underlying" rate of inflation. Food and energy prices are extremely volatile from month to month as a result of temporary supply disruptions caused by weather or political crises. By stripping out food and energy prices, the authorities can tune out short-term deviations and focus on stable price trends in order to monitor long-term changes in prices. Many economists consider core CPI as the more dependable measure of the supply and demand interplay (minus the supply shocks) and actual levels of inflation.
Consumer Prices in Perspective
Alongside the recent spike in consumer prices, the term ‘above-target inflation’ is also often being quoted. In December 2003, then-Chancellor Gordon Brown introduced the target for inflation to be within 100 basis points of 2%, i.e. within the 1%-3% range. The change aligned the U.K. inflation policy with that of the European Central Bank and was meant to make the adoption of the euro in the U.K. easier, should the Government change its mind about the common currency.
Prior to that point, the inflation target was 2.5% as measured by the RPI. Inflation targeting, as a policy, was introduced in 1992 and that has led to a period of relative consumer price stability. To put inflation in perspective, prior to the 1990s, Britain had seen a 25% hike in consumer prices during the 1970s’ oil shock, a 50% appreciation during the Second World War and deflation during the Great Depression.
Comparing Inflation Measures
Note that neither figure should be taken strictly at face value. Although core CPI might be the better measure of underlying inflation, headline CPI might reflect a longer-term trend that's worth investigating--for example, a spike in commodities prices as a result of burgeoning developing economies may make it unlikely that their prices will revert to the mean anytime soon.
Core and headline CPI often diverge substantially in the near term. For example, in June, the annual change in core and headline CPI was 2.8% and 4.2%, respectively, reflecting a notable slowdown in commodity prices that month.
In addition to CPI, the ONS calculates a Retail Price Index (RPI). The goods and services the RPI covers are slightly different from the CPI. Notably, the RPI includes items relating to housing costs, such as mortgage interest payments and council tax. The difference between CPI and RPI can be of note in itself. For example, the latest inflation figures released in the U.K. revealed that RPI stood at 5.0% year-on-year in July, whereas annual CPI was ‘just’ 4.4% in comparison. RPI is used to calculate the coupon payments of index-linked gilts.
Caveats of Headline CPI
Even though the widely quoted headline CPI might be a better measure of the actual consumer experience than core CPI, bear in mind that neither measure is a perfect reflection of inflationary pressures for all individuals at various points in time.
For starters, CPI does not consider changes in quality of goods and services. Although consumers benefit from higher-quality products, improved quality often results in an increase in prices. CPI, however, assumes no change in quality and attributes the rise in prices to inflation.
One other caveat of CPI is that when prices go up, consumers tend to reduce consumption of more expensive products in favour of cheaper alternatives. For example, a rise in beef prices when pork prices remain stable may cause consumers to shift away from beef to pork. But because CPI uses a fixed basket of goods and services, it assumes that people are purchasing the same basket of products regardless of price fluctuations. Therefore, consumer expenses may not be as large as the CPI figures imply.
Lastly, neither headline CPI nor the other inflation indices are an absolute yardstick for the cost of living. The cost of living, as a concept, usually refers to the price of basic essentials. What constitutes basic essentials can vary significantly from household to household. For example, a change in the price of cigarettes, for example, following a VAT increase will naturally impact a smoker’s budget much more than a non-smoker’s budget. The same logic applies to the inability of CPI to accurately reflect inflationary pressures in varying geographic regions.
Esther Pak is an assistant site editor of Morningstar.com. This article was updated for the U.K. by Morningstar.co.uk assistant site editor Dea Markova.
