Were prices really falling? What you MUST know about inflation

Around the world, politicians and central bankers have been worried about the cost of the stuff we buy not being high enough. Official UK inflation has hovered around zero for a year, and is only slowly starting to rise – today’s CPI reading of 1.8% was the highest since June 2014.

According to the warped logic of our political and economic overlords, if prices are not rising we are headed for catastrophe, the so-called “spectre” of deflation is threatening to derail our economies. But forget the flawed arguments, and also try not to think about why they think prices should go up by 2% and not some other number. Let’s start with the basics: are they telling the truth when they say prices are not rising? Many ordinary citizens, feeling the strain on their personal finances, have a suspicion that prices rises are not really as muted as they are being told.

For starters, one may wonder if the official inflation number, regardless of composition and calculation method, is an appropriate number to measure price rises. In the UK, as in most other countries, the measure of inflation is the Consumer Price Index (CPI). CPI, being a measure of consumer cost, does not include government goods and services, so for example, an increase in the cost of government provided healthcare is not reflected. Of course, the NHS has been enjoying increased spending over recent years, and in 2013 the UK spent 9.1% of GDP on health related items. The CPI weight is a mere 2.5%. CPI may be a measure of prices of goods and services on which people actually spend money themselves, but in an economy where the government spends almost 45% of GDP it seems unreasonable to exclude public spending from a measure of price rises more generally. The UK spends 2% of GDP on the military, so should a measure of how prices move not include aircraft carriers and nuclear submarines? Much more could be said, but the conclusion is clear: CPI is highly selective in what prices it shows to be rising or falling.

However, even as a measure of consumer price rises there are problems with the CPI. The basket of goods on which CPI is calculated is adjusted every year, both in terms of components and weights, to reflect changes in consumer behaviour. This is reasonable enough, but means that CPI inflation does not measure actual price rises, but is more akin to a cost-of-living index. As long as the adjustments are reflective of actual behaviour and price movements this is perfectly fine, but is this actually the case? The Office for National Statistics (ONS), which calculates official inflation in the UK, determines the new basket of goods which is be used to measure CPI on a yearly basis. Last time they did this in came stuff like meat-based snacks and women’s leggings, while organic carrots and boy’s branded sports tops were among things leaving the index. Of course there is a method to these changes, but to say that it is subjective is putting it mildly, and of course no individual’s consumption exactly matches the ONS’s basket.

Then there is the huge issue of how technological advances are contributing to prices, as for example increased computing power means that the price of a PC will be reflected in CPI as having dropped even if the actual price consumers pay stays the same or even goes up. There is a sophisticated methodology behind these quality adjustments, known as hedonic regression, and the contribution is always a drop in prices. There are other ways the data is adjusted, including for seasonality and volatility (so a rise in for example energy costs is not immediately reflected to its full extent). Again, the conclusion is that CPI is a highly subjective measure of inflation, and ripe for manipulation.

There are also more direct ways the government has managed to make inflation appear lower than is actually is. In December 2003 the official measure of inflation was changed from RPI to CPI. A subtle difference to the majority of the electorate, but RPI has in fact consistently been higher than CPI, since 2012 on average by almost 0.7%. One reason is technical: CPI predominantly uses geometric mean, which has the great advantage (to the government) that it is always lower than or equal to the arithmetic mean – which is how RPI is calculated. As a rule of thumb, this means that if CPI was calculated in the same way as RPI, it would be about 1% higher. There are also key differences in the constituent parts of the two indices, the most important one being that RPI includes a cost of housing element, namely mortgage rates, house depreciation and council tax. It is interesting that CPI does not include the cost of housing, despite this being the single biggest expense many people have. Also note that RPI does not include house prices, but mortgage costs and house depreciation. Mortgage costs of course have been relatively stable in the last decade, as rising house prices have been offset by the low interest rates which caused house prices to increase in the first place. Including house depreciation as a cost, rather than house appreciation as a price rise, is also an interesting choice. You might think it was purposefully trying to deceive.

The reckless money printing pursued by central banks across the world must inevitably lead to price inflation, and although this process has been subdued and delayed by several factors, it is highly questionable whether the story told by CPI is true. Shadowstats.com report an alternative inflation measure for the US, which for a decade has consistently been around 7% higher than official CPI. It is fair to assume a UK statistic would look similar.

So why would the government want inflation to appear lower than it actually is? One reason is that low inflation makes nominal GDP appear higher in real terms (note that the GDP deflator measure of inflation is different from CPI inflation in that it is not confined to consumer goods and includes only domestically produced goods), so it is a convenient way to make growth look better than it actually is. Then there is “tax bracket creep”, where inflation pushes income into higher tax brackets. But the most sinister reason was described by none other than J.M. Keynes when he wrote that “by a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” By inflation the government can reduce the value their nominal debt, effectively taxing their creditors by stealth. In an age where so much of Keynes’ theory is followed blindly by governments, maybe we citizens should heed his warning about inflation and trust our gut instinct that prices are rising, even though the authorities have told us otherwise.

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