Back to basics: Inflation

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By Rachel Norman, lecturer

4 June 2018

What does quiche, leggings and edam cheese have to do with consumer spending levels and interest rates? We go back to basics on inflation.

One of the challenges faced by a government is to manage the level of inflation experienced in an economy. Module 11 of the TC Finance course discusses some of the economic theories surrounding inflation, and this article provides further background; students should note that only the module content is examinable.

What is inflation?

Inflation can be defined as a sustained increase in the price level of goods and services in an economy. The UK government sets a target rate of inflation for the Bank of England (currently 2%).

In order to try to meet this target, the Bank of England will change interest rates to try to encourage consumers to either spend or save more. When consumer spending is high, inflation tends to be high, and vice versa.

A government wants to keep inflation in check to avoid problems caused by inflation either being too high or too low. The term “hyperinflation” refers to very high levels of inflation, such as that seen in Zimbabwe around 2007-2009, and in post-war Germany where inflation reached 30,000% per month after the end of World War I.

Inflation can also be negative, known as “deflation”; the terms “deflation” and “disinflation” are often confused; the latter refers to a fall in the inflation rate rather than the rate itself being negative.

How is inflation measured?

Although there are several possible measures of inflation, the Government’s inflation target is assessed using the Consumer Price Index (‘CPI’).

This is published every month by the Office for National Statistics, by looking at and tracking what they consider to be a representative “basket of goods” that represents typical household spending across areas such as food and drink, entertainment and travel.

Although similar to the slightly more famous Retail Price Index (‘RPI’), there are differences between the two, for example, things like mortgage interest costs and council tax are included in RPI but missing from CPI.

There is a hybrid measure called CPIH - which extends the traditional CPI to include these housing costs -  but does not take account of the other differences to RPI.

What is contained in the “basket of goods”?

The contents of the “basket of goods” used for the calculation of CPI changes over time with consumer spending trends and fashions.

At present there are approximately 180,000 separate prices feeding into the CPI calculation, covering around 700 different goods and services, collected in over 100 locations around the UK.

The following table illustrates the weightings of the various categories, as published by the Office for National Statistics in 2018.

Table 1: Allocation of items to Consumer Prices Index including owner occupiers' housing costs (CPIH) divisions in 2018

    CPIH weight, Jan 2018 (per cent) Observed variation in price changes1 Representative items2 (per cent of total)
1 Food and non-alcoholic beverages 8.2 Medium 24
2 Alcohol and tobacco 3.3 Medium 4
3 Clothing and footwear 5.9 Medium 11
4 Housing and household services 30.0 Low 5
5 Furniture and household goods 5.0 Medium 10
6 Health 2.1 Low 3
7 Transport 12.4 Medium 6
8 Communication 2.0 Medium 1
9 Recreation and culture 12.0 Medium 17
10 Education 1.8 Medium 1
11 Restaurants and hotels 9.7 Low 7
12 Miscellaneous goods and services 7.6 Medium 11
Source: Office for National Statistics

In 2018, additions to the basket of goods included quiche, raspberries, chilled mashed potato, highchairs and exercise leggings, while the list of items removed included pork pies, edam cheese, leg waxing and digital camcorders! Below are just a few of the movers and shakers on the list:

In the basket of goodsOut the basket of goods
QuichePork pie
Cooked pastry-based savoury snackPasty / savoury pie
Digital media playerDigital camcorder
Women’s exercise leggingsWomen's outerwear
Punnet of raspberriesPeaches / nectarines
Prepared mashed potatoEdam cheese
Television (39-40in or larger)Television (14-22 in, 23-32 in, 33in)
Action cameraDigital camcorder

The full list of goods is available for download.

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