Inflation is a measure of changes in the cost of living. It is calculated by using statistics such as Consumer Price index CPI, retail price index RPI. The process for measuring inflation is broadly
- Creating a weighted basket of goods – depending on frequently goods are bought
- Measuring monthly changes in prices.
- Creating an index from the price change multiplied by the weighting of the good.
Difficulties in measuring inflation include
- Changes in the quality of goods. Changes in the quality of goods mean that price rises may not reflect inflation, but just the fact it is an improved good. For example, computers have many more features than 10 years ago, so it is difficult to compare prices because they are effectively different goods.
- Shrinkflation. It is also possible goods can deteriorate in quality and size. For example, the price of vegetables may stay the same, but if the size decreases, the price per gram effectively rises. Shrinkflation has often been a response to rising cost-push inflation – firms reduce the size of chocolate bars rather than increase the price. Inflation measures may not pick up on this marginal decrease in size.
- One-off shocks may give a misleading impression. For example, a rise in oil prices will lead to higher inflation. But, this rise in prices may just be temporary. Tax changes have a similar effect.
- Which measure to use? – There are numerous different measures of inflation which include different items in the inflation index. Measures of inflation include CPI, CPIH, RPI or RPIX. CPI excludes mortgage interest payments. CPIH includes them. See: Differences between RPI, RPIX and CPI
In 2009, with falling interest rates, RPI gave a negative inflation rate, whilst CPI was positive. There is often a difference between the two measures. A rise in interest rates causes RPI to rise but not CPI. Therefore, it is important which measure is used. The government’s preferred measure is currently CPI.
- Different groups can have different inflation rates. Rising electricity and gas prices may affect old people more than young people. Therefore, old people could have a higher inflation rate than the national average. This is important if pensions are index linked because their cost of living may rise more than prices causing a decrease in living standards.
- Basket of goods can become outdated. In a fast-changing economy, goods people are buying is frequently changing. Trends may cause people to be buying new technology or in different places – and the traditional basket of goods can fail to keep up. For example, if there is a rise in internet shopping, inflation measures should give a higher weighting to online prices, but it takes time to update the basket of goods and which prices should be counted.
- Different measures of Inflation. As well as CPI, the government also calculate different methods of inflation like RPI and RPIX. RPI includes housing costs and therefore, recently has given a higher value of inflation.
- Chain Weighted Index. If the price of one good goes up, it may automatically change peoples spending patterns. Therefore, they stop buying the more expensive goods. Therefore, the price that they actually pay stays the same. A Chain Weighted index takes these changes in quantity into account.
- Core Inflation. Often there may be a temporary spike in inflation because of a rise in volatile goods such as energy prices and food. Therefore, the headline CPI rate may give a misleading impression to underlying inflation. See: difference between CPI and Core CPI inflation
Example of Core Inflation and CPI inflation in the US
- Blue line – CPI
- red line – Core CPI – without volatile prices.
In 2008, the US experienced a jump in headline CPI inflation, but this included a temporary increase in oil prices. In 2009, oil prices fell causing a fall in headline rate.
Different Types of Inflation Measures
- RPI – old headline inflation rate
- RPIX – RPI less mortgage payments this is the underlying rate.
- This is used because interest rates are increased to reduce inflation but this higher interest rates increase the cost of mortgage repayments
- RPIY = RPIX less taxes (This is sometimes known as the harmonized rate)
- CPI – Consumer Price Index
- Different measures of inflation
Attempts to Overcome the difficulties of calculating inflation
- The Billion price project is an attempt to include a much wider range of published prices across the internet. BPP index at Mit