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COMMENT
A few weeks ago, I read some market research (don't ask me where it came from!) which claimed that most British adults couldn't properly explain what inflation is. In the simplest terms, inflation measures past price rises. So, with annual inflation at, say, 2%, goods costing £100 last year now cost £102. Of course, the prices of some goods rise more strongly than others, and cheap imports from the likes of China have recently brought down the cost of, for example, clothing. Hence, the headline rate of inflation blends together the costs of many goods and services to produce an overall average. But, as a mathematician, I often say, "Averages invite comparisons"! Naturally, your own personal inflation rate will be different to your next-door neighbour's, for example, since we all have different spending habits. Still, the government has created, and continues to monitor, three main measures of inflation (here's an explanation of the differences between these three): Consumer Prices Index (CPI) This was set at 100 in January 1996 and, as at June 2005, it was 113.5. In other words, over 9½ years, this index has risen at a little over 1.3% a year compounded. The Bank of England's Monetary Policy Committee uses the CPI as its inflation target, currently 2%, and raises or lowers the Bank's base rate in order to meet this target over the medium term. Retail Prices Index (RPI) The RPI is normally higher than the CPI, simply because the CPI excludes housing costs. (Why? Has the Treasury assumed that Britain is now a nation of new-age travellers?) The RPI is a wider measure of living costs, since it takes account of council tax, mortgage interest, buildings insurance, estate agents' and conveyancing fees. Housing costs have risen strongly in recent years, so if you're a homeowner (and seven out of ten households are owner-occupied), the chances are that the RPI is a closer match to your personal inflation rate than the CPI will ever be. The RPI has risen from 100 in January 1987 to 192.2 in June 2005, at a compound annual rate of 3.6% over 18½ years. Currently, the RPI is about 2.9%, so it suggests that living costs have risen by just short of 3% over the last twelve months. RPIX The RPIX is simply the RPI with mortgage interest payments stripped out. Since 1987, it has risen slightly slower than the RPI, at 3.5% a year. As the RPIX has been higher than the RPI, we can deduce that, over this period, mortgage interest payments have risen faster than general living costs. Inflation is usually factored into wage negotiations, particularly in the public sector. However, with the current inflation target at a historically low 2%, it's hard for workers to call for an inflation-busting pay rise without agreeing to productivity improvements or changes to working practices. (By the way, here are my ten tips to win a bumper pay rise.) However, in the past, high inflation has gone hand-in-hand with higher wage demands. Rapidly rising wages and prices are good for borrowers, because above-average inflation erodes the value of their debt burden faster. On the other hand, high inflation is bad news for savers, because it means that their carefully hoarded money will have less buying power in the years to come. At present, a first-class no-notice savings account paying, say, 5% a year produces an after-tax return of 4% for a basic-rate taxpayer, or 3% for a higher-rate taxpayer. Hence, most savers aren't making a return on their money after tax and the RPI measure of inflation. Ouch! That's one reason why my savings and investments are sheltered inside these delightful tax-free wrappers. Personally, I tend to laugh in the face of the official inflation measures, as they have little bearing on my personal financial reality. Thanks to a tripling of the oil price over the last three years, my domestic energy bills have gone through the roof (pun intended). Also, the cost of diesel for my wife's car has leapt well above the rate of inflation. My council tax has absolutely rocketed in the last two years, and my childcare costs are rising by about 5% a year. In addition, the government likes to raise 'sin taxes' well above the general rate of inflation, so my vices cost me more and more each year! Another point worth noting comes from an article in Saturday's Financial Times. In the FT, Alexander Jolliffe warned that older people face far higher inflation than young consumers, because of their higher spending on healthcare, utilities and council tax. So, you're likely to need much more in your pension pot than you think! As you've probably figured out, the only real way to establish your individual inflation rate is to compare this year's expenses with last year's. However, this requires quite a lot of effort, record-keeping and discipline, so it's not for me! Still, I guesstimate that my household bills are rising by at least 5% a year, so I'm always on the lookout for ways to slash my bills. Here are four articles which will help you to do the same - good luck with slashing your personal inflation rate! More: Get a better savings account | Hack your household bills | Avoid paying interest: use a 0% credit card!