The effect of inflation hits us in the pocket

Apr 27 2008 Personal Finance by Trevor Law

According to Government figures, the current rate of inflation is 2.5 per cent. Tell that to virtually anyone in the street and you’re likely to get a hollow laugh and a curt answer: "Not for me".

Most people have the feeling that their cost of living is growing at a much greater rate.

Food prices have shot up over the last 12 months, fuel bills are rising, the credit crunch has forced mortgage rates up and increases in council tax and petrol duties are adding to households’ domestic expenditure.

The difference between official statistics and people’s perception is large and growing. Is this another example of the Government manipulating data to make itself look better and how does it affect our daily lives?

It is worth starting at the beginning by defining what inflation is, how it is measured and how it affects the economy. Inflation is a sustained rise in prices across an economic area – literally 'the cost of living'.

In Britain it is calculated by monthly measuring the percentage rise in price of a weighted sample, or basket, of goods and services that a typical household buys, compared to the year before.

In classical economic terms, it is caused by demand exceeding supply: in other words, too much money is chasing too few goods and services, so they begin to command higher prices.

It seems to be a natural state of affairs in advanced capitalist economies.

Inflation is not necessarily a bad thing. A moderate level of inflation is a sign of a strong economy with a high level of activity.

If you are a borrower, inflation works in your favour as the cost of your borrowing reduces over time.

Inflation becomes a problem when it is permanently high or rising. It reduces the buying power of money so wages have to increase in line with inflation for people to keep up.

This tends to produce a vicious cycle where increased wages fuel inflation which pushes up wage demands. The value of peoples savings and pensions is reduced.

The biggest problem though is that high inflation causes uncertainty and lack of confidence.

Businesses don’t invest and people don’t save. It also points to fundamental weaknesses in an economy, resulting in a falling exchange rate which in turn tends to push up inflation.

Gordon Brown only has himself to blame for the scepticism among economists, politicians and the public about the inflation figures.

For decades the so-called Retail Price Index (RPI) was the official data.

But as Chancellor in 2003, Mr Brown switched to the Consumer Price Index (CPI) which strips out some of the largest household expenses such as mortgage costs, council tax and rent.

There are reasonable economic grounds for doing this.

Firstly, it is the generally accepted measure used in most Western countries, so direct comparison is easier.

Secondly, mortgage rates were seen to be having too high an effect on the RPI, especially in periods of high interest rates and as house prices became more volatile.

Also, changes in tax rates are not really an indication of changes in economic activity. The argument goes that a transfer of wealth from one group to another (taxation) is not in itself inflationary.

However, the switch has caused problems. The Government has been accused of manipulating the figures: CPI is generally much lower than RPI – 2.5 per cent as against 3.8 per cent at the moment. So it makes them look better.

RPI is a much better indicator of how a household’s costs are rising.

As an economic measure, CPI may be better, but if mortgage costs and taxation are actually rising, people are directly affected.

They know that the rise in their cost of living is accelerating even if official figures suggest it is not.

If you work in the public sector you could be even harder hit as the Government insists that CPI is used as a base for all salary negotiations and they are generally offering "below inflation" increases.

In the private sector, RPI is a more generally used measure.

Of course, if nobody believes the official statistics anyway, it doesn’t matter which measure you use. Any inflation measure can only ever be an average which won’t reflect any individual’s circumstances.

It seems that at the moment the official measure is more out of line with more people’s experience than ever before.

Fuel for transport is up 20 per cent in the last year, mortgage charges by 11 per cent and even food is up by six per cent.

What is keeping the official inflation rates down are falls in the price of clothing, furniture and electrical goods.

What you spend on each area will affect your personal inflation rate.

The Office of National Statistics even has a personal inflation rate calculator on its website.

In terms of recent history, Britain is going through an unprecedented period of low inflation, but if people start believing that their actual level of inflation is much higher than the official one, it could lead us back to the inflationary spirals of the past.

This is particularly concerning at a time when pressure on inflation is high anyway and the credit crunch is beginning to affect all sectors of the economy.

The Government and the Bank of England have a hard job keeping inflation down without slowing the economy too much.

They may have an even harder job convincing the populace that the official figures have any relevance to their own experiences.

*  Trevor Law is a director with Montpelier Group (Europe), the privately-owned independent financial advisers located at Barston near Solihull. E mail: TILaw@montpeliergroup.com