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. 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- Basket of goods can become outdated.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 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