Inflation – the facts

Alasdair Macleod – 19 May 2010

Yesterday, the UK’s Office for National Statistics announced that the CPI rose by 3.7% in April, compared with a 3.4% rise in March. The ONS is referring of course to a moving annual rate, which reflects price changes dropping out of the statistics a year ago as well as changes today. The increase was greater than expected, which raises the possibility that perhaps all the quantitative easing of the last eighteen months may be beginning to feed through to prices.

Unfortunately, there is no definitive link between monetary and price inflation; furthermore the ONS’s definition of CPI reflects the internationally accepted definition. While statisticians have taken care to produce indices that are internationally comparable, they do not necessarily reflect true price inflation. When looking for this truth there are two points to consider: the make-up of the CPI includes many discretionary purchase items likely to be dropped or deferred in a downturn, and there are substantial price distortions arising from government and local authority spending. Inclusion of discretionary spending items necessitates continual adjustment making true comparisons difficult; and to illustrate the latter point, how does one deal with spending on health and education, a major component of any family’s expenditure, but mostly provided by the state? A true CPI should also be cleansed of capital goods.

As always in economics, the truth is a matter of judgement and logic, rather than just statistics. The statistics should therefore be cleansed to include only those items considered essential in good times and bad. The consumption categories that meet all these criteria in the UK statistics are three: food and non-alcoholic beverages, housing and utilities, and transport. Together they represent only 40% of the CPI.

The results of this thinning are notable, and are shown in the chart below, where the CPI and relevant sub-indices are rebased to March 2004 at 100:

From this it can be seen that the CPI understates inflation by a substantial margin. Furthermore, the food and transport subsector indices are likely to rise further in the coming months as a result of weak sterling. The utility element of housing, which includes heating oil, gas and electricity, will be similarly affected. Our redefined core measure of price inflation is not only rising faster than the CPI, but will continue to do so.

If there is a renewed economic downturn, this trend is likely to continue to be obscured by falling prices for non-essential goods and services, while more excess capacity is eliminated from them. From then on, price inflation will rapidly become a more obvious and intractable problem.

Yesterday’s CPI release may have surprised City economists, but they ignore the true cost of monetary inflation. The dénouement will be painful, and is consistent with the accelerating slide in sterling.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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