What is Inflation?

Inflation records the change in the change in the price of goods and services bought. Inflation is one of the most issues affecting the management of the economy.  Inflation influences the setting of interest rates. For savers, it will affect the return on their investments. For housebuyers, inflation rates can influence the cost of borrowing and the ability to buy a new property.

Inflation also affects how much income that pensioners receive, since increases in pensions are often linked to the rate of inflation. Prices in some privatised industries are also often linked to the rate of inflation.

Inflation measures the rate of change of prices for goods and services. There are a number of different measures of inflation. Each measure looks at the price of hundreds of things firms and consumers frequently buy, ranging from bread, to music, and the price of a pint of beer. They are:

• RPI– the Retail Prices Index or Retail Price Index (RPI) is a measure of inflation published monthly by the Office for National Statistics. It measures the change in the cost of a representative sample of retail goods and services. RPI includes housing costs such as mortgage interest payments and council tax.

• RPIX – RPIX is the same as RPI with the exception that it does not include mortgage interest payments

• CPI – The Consumer Prices index relies on the HCIP (Harmonised Consumer index prices). The HCIP uses internationally agreed standards, enabling inflation across Europe to be compared. CPI is calculated on a formula that takes into account that when prices rise, some people will switch to lower priced alternatives. .

• RPIJ -This is a new inflation measure which is due to be introduced in March 2016. This measure is intended to supercede the RPI index which has been described as “flawed” by Jill Matheson (The UK’s National Statistician). The new index will replace the RPI in March next year and will use a different formula to calculate the index using the “Jevons” formula (hence the term, RPIJ). Despite the introduction of the new measure the RPI will continue to be published.

The most frequently quoted and most significant measures of inflation are the Consumer Prices Index (CPI) and the Retail Prices Index (RPI). There are a number of differences between the two measures. RPI includes housing costs and council taxes, in its calculation of the rate of inflation. CPI does not included either cost in the calculation of the inflation rate.

In all cases the inflation rate is recorded as a percentage. For example, if CPI is 2% this means that on average the price of goods and services is 2% higher than the previous year. As a result, we would need to spend 2% more in order to buy the same things that were purchased last year.

Why is the inflation rate important?

Researchers monitor the prices of thousands of items consumers regularly buy in order t identify changes in prices.

The data from the Consumer Prices Index and the Retail Prices Index are used in a variety of ways by business and government. The data collected plays a significant role in determining economic policy. The Bank of England uses the data to set interest rates. Responsibility for setting interest rates rests with the Monetary Policy Committee. If the Monetary Policy Committee, for example believes that inflation will increase so that it is above 2% during the course of the next 18 months, I may decide to increase interest rates in order to try and dampen Aggregate Demand and reduce inflationary pressure.

On the other hand if the Monetary Policy Committee judges that inflation is likely to be below 2%, it may decide to reduce interest rates. The aim here would be to increase Aggregate Demand.

The knock on effect of changes in inflation rates is that they will in turn determine the rates that banks

That’s why inflation is a crucial factor in determining the interest rates banks offer savers. They will also the cost of borrowing for homebuyers and consumers making large purchases using credit.

Inflation rates will also have an impact on household income. State benefits and pensions are index liked so that they rise with inflation. The faster the inflation rate rises, the faster index linked payments and benefits will rise. A note of caution needs to be raised here. While pensions and benefits increase in line with inflation it does not mean that people will be better off

Anything that is described as index-linked rises in line with inflation.

That includes state benefits, pensions and – in part – some train tickets.

Some companies use the level of inflation to set annual pay rises. Recently, however, due to the effects of the recession, many pay settlements have fallen behind price rises.

How is inflation calculated?

Each month the Office for National Statistics (ONS) gathers the current price of 120,000 goods and services from online retailers and traditional retailers across the country by researchers who visit the same retailers each month in order to track the price of identical goods. The information is combined on the basis of average household spending patterns in order to compile a price index.

In order to reflect the increased importance of certain items, they are weighted (given greater importance) in the inflation index, reflecting how much we spend on these items.

For example consumers typically spend more on petrol and heating costs than they do on stamps

It also takes into account how much we spend on different items. A sharp rise in the price of petrol would affect the overall inflation rate because petrol has a weighting of 4% in the Retail Price Index.

In contrast postage stamps, have a weighting of only 0.1%. An increase in the cost of posting a First Class letter would have a minimal impact on the rate of inflation.

Task

As a pensioner, consider whether you would rather have your pension adjusted using the RPI or the CPI index.