Inflation is one of the issues that is covered in the financial news the most. Someone appears almost daily warning that money printing will make us resemble Zimbabwe again. Individuals are now more concerned than ever since massive amounts of stimulus are being injected into economies around the globe to keep people and businesses viable during the pandemic. What exactly is inflation, and how is it calculated? Is it always harmful, or is a tiny amount required? Here is our brief guide to inflation.
What Is Inflation?
There are several angles from which to view inflation. However, the most basic explanation of inflation, and what the majority of people believe it to be, is a rise in the average price of goods and services that consumers purchase. The word “overall” is important here. The majority of individuals purchase a wide range of goods and services each day, which fluctuate in price in various ways. Some of these items, like food and power, have more obvious price increases than others. Additionally, not everyone purchases the same same items: a teenager’s shopping basket will differ greatly from a pensioner’s. As a result, different groups of people will be impacted by price changes in different ways.
Inflation In The UK
You can already tell that there is considerable area for disagreement regarding the best way to calculate inflation. However, the Office for National Statistics creates an index based on a basket of products and services that the average individual consumes in an effort to provide a broad notion of how the cost of living is changing. Numerous pricing and spending surveys are conducted, and the baskets are frequently updated, to ensure that the index accurately reflects what consumers are actually purchasing and that price changes are accurate.
The Consumer Prices Index (CPI) and the older Retail Prices Index are the two most important indices in the UK (RPI). Most other nations only employ a CPI-style formula (also called the Harmonised Index of Consumer Prices in the EU).
A Guide To Inflation – RPI v CPI
The primary distinction between these two inflation indices is that, whereas the CPI excludes housing prices, the RPI does. RPI inflation is therefore typically (though not always) higher than CPI inflation.
Housing costs are not included in the CPI since they are considered an asset rather than a good, contrary to the claims of critics who claim this understates inflation. They contend that a hike in interest rates to slow the economy (and lower inflation) would actually increase inflation since it would increase monthly mortgage payments, which are factored into RPI. This is because many mortgages have variable interest rates.
Guide To Inflation – Calculations
The two approaches use slightly different formulas to calculate the results. While CPI is computed geometrically, RPI is calculated arithmetically. The latter model accounts for consumers’ propensity to adjust their consumption of items in response to price increases. It should have a negligible impact, as it does in other nations. However, the disparity is substantially larger because of peculiarities in how the cost of clothing and footwear is determined. In fact, according to analysts, these two groups are responsible for about two-thirds of the difference between the CPI and RPI.
Because of this discrepancy, governments are increasingly eager to update their tax and benefit databases using CPI.
Measuring Problems
Other small problems with inflation metrics exist as well. For instance, some experts contend that including food and energy in the basket is pointless because of how variable their prices are. The “core CPI” is the name of the resulting index. Others disagree, arguing that regardless of how volatile they are, excluding significant expenditures from price estimates makes no sense.
How to accurately gauge changes in product quality over time is still up for dispute. For instance, you can get a much better laptop for £1000 this year than you could a decade ago. While the majority of individuals agree that some modifications are necessary to reflect the quality improvement, some contend that the techniques employed (known as “hedonic adjustment”) go too far.
Last but not least, there are claims that some nations, most notably China and Argentina, fabricate inflation data. Argentina, for instance, has practically outlawed the creation of independent statistics.
