January 26, 2007 12:28 pm

Inflation

Inflation is approaching its highest level in 14 years in the UK. So, this seems a particularly good time to come to grips with its real meaning, how it is calculated and what its effects are.

In simple terms, inflation is the rise in the level of prices against a particular benchmark.

Two common measures of inflation are the consumer price index (CPI) and the retail price index (RPI). The RPI is the most comprehensive measure, covering goods and services bought by most households. The RPI also includes housing costs such as mortgage interest and council tax, which the CPI does not.

In the year to December 2006 the consumer price index rose by 3 per cent. This was quite a significant jump given that the Bank of England’s target was a full percentage point lower than that. The Office for National Statistics has been trying to defend itself against accusations that it underestimates the rate of inflation experienced by most Brits.

On a particular day every month, thousands of ONS inspectors collect 110,000 prices for more than 650 goods and services in 150 places and over the internet. These include goods such as bread, cereal, furniture and clothing as well as the price of water, gas and electricity.

The ONS has launched a personal inflation calculator on its website so you can see how your spending pattern is likely to deviate from the average for the retail price index. Visit www.statistics.gov.uk/pic/.

So what causes inflation?

When demand increases for certain products such as houses or cars, while supply remains the same or diminishes, this usually results in rising prices. As one analyst says, inflation comes about when “too much money is chasing too few goods”.

What is the consumer price index?

This index of consumer prices was set up in 1993 by Eurostat, the European Union’s statistical unit, for measuring inflation among member states. The CPI was given by Gordon Brown, the Chancellor, to the Bank of England as a target measure for growth in December 2003. Previously the Bank of England had used the retail price index excluding mortgage interest payments (RPIX) as its target measure.

The CPI has advantages over the RPIX in its method of calculation. It uses a wider sampling of the population and is also the European standard measure. Its main drawback is that it does not include housing costs.

The ONS emphasises that the CPI is not designed as a cost-of-living indicator but is a “macroeconomic” measure.

This index is about 100 years old and is the most comprehensive in the range of services and goods covered. But the RPI excludes the richest 4 per cent of people – on the grounds that their spending is not likely to reflect that of an average household. It includes housing costs, such as mortgage interest payments and housing depreciation – the cost of major repairs to keep a house in good order. Designed as a “compensation” index, it is used to index a range of incomes and prices, including pension payments, state benefits and national savings.

Does inflation have much of an effect on investments?

Unquestionably. If your investment in equities, bonds or even art grows at say 5 per cent a year but inflation is 4 per cent, then your assets are growing by only 1 per cent in real terms. Inflation is therefore a threat to all investments and savings. You need to be comfortable that your capital will grow by at least the inflation rate so you do not lose out in real terms.

How does it influence your income?

Let’s assume you generate £50,000 annual income now, but it stays fixed at this level in the future. Inflation means the income will be worth progressively less in real terms and this can have a significant impact over 20 or 30 years.

For example, assuming inflation of just 2 per cent per year, £50,000 would be worth just £33,338 in real terms after 20 years. This is why it is vital to incorporate protection against inflation when planning for long-term investment or retirement income.

It is especially important when buying an annuity with your pension. Inflation-linked annuities pay far less income initially (perhaps around half) than conventional level annuities. You therefore need to work out how long you would have to live to break even if you took out an inflation-linked annuity, before deciding which route to take.

What impact does inflation have on the property market?

It’s quite mixed. High inflation can be good for borrowers because they know their earnings are likely to rise rapidly. This encourages people to take out bigger mortgages. And as their earnings are likely to increase, the cost of paying off their debt could fall. So the housing market can be stimulated during a period of high inflation.

However, in times of slower house price growth, high inflation could mean that house prices fall in real terms, although it is quite unusual for them to fall in monetary terms. Another negative is that the Bank of England usually acts to curb rising inflation by lifting interest rates. This tends to slow growth in the property market and raise the cost of borrowing. Interest rates now stand at 5.25 per cent and some economists believe another rate rise is likely this year. House prices have grown rapidly in the past year but a further interest rate could cool the market.

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