In the first of a new series on economic topics, we look at the current state of inflation in the UK.
In today's economic climate, the two financial measures that will affect people the most are interest rates and inflation. When we have very low interest rates and high inflation, coupled with stagnating wages, we're in a serious wealth-destroying environment.
Everyone who is currently earning money is seeing the value of what they take home being eroded, and careful savers are having their nest-eggs scalped to pay the costs of getting us out of our current economic mess.
The Consumer Price Index (CPI) rise for September was measured at 5.2%, up from August's 4.5%. But what actually is it and how is it measured?
CPI, and its related figure, the Retail Price Index (RPI), are measures of inflation -- that is, the rate at which prices are changing. The two are calculated slightly differently, and some will wonder why we need both.
The main reason is that RPI is a specifically British measure that has been around since 1947, while CPI is an international standard introduced to the UK in 1997, used widely in the EU and in the USA, and which allows us to compare different countries against each other in a more meaningful way.
Of course, a cynic might suggest that having the two gives governments the chance to use whichever benefits them the most and us the least, as we saw this year when the ISA limit calculation was shifted to use CPI inflation rather than RPI.
The technical details
Both the Retail Price Index and the Consumer Price Index attempt to measure changes in the prices of goods and services commonly purchased by the average UK family, with the main difference being in the classes of items included.
Obviously, it would be impossible to assess the prices and amounts of all goods and services purchased over the course of each month, and so a "basket" of items which are thought to be representative is selected instead. It's a pretty big basket, containing several thousand items, all of which have their prices checked and weighted according to estimates of the quantities that people buy.
The new value of the index is compared to an old value, typically a year previously, and the percentage difference is then quoted. So saying that the CPI for September is up 5.2% means that the price of the CPI basket is 5.2% higher than in September last year.
Every year, the contents of the baskets are re-examined and adjusted to reflect changes in our shopping patterns.
The 2011 CPI basket saw a number of new items added, including oven ready joints, medium density fibreboard (apparently it's gaining market share over hardboard), and dating agency fees.
At the same time, the items ejected from the old 2010 basket included women's high heeled sensible shoes, rose bushes, and vet fees for spaying a kitten.
The main difference between the two measures is that the CPI excludes a number of housing related items, like council tax, mortgage interest, buildings insurance, and estate agents' fees.
Also, the CPI has a few extra things in that the RPI does not, and the actual calculations are done slightly differently. All of those differences lead to CPI inflation usually being slightly lower than RPI inflation.
CPI inflation is increasingly becoming the UK standard, with the RPI being left behind.
The current state
What we really need, economically, is a low and steady inflation rate -- the bank of England has historically been targeted with keeping inflation within 1 percentage point of 2% per year.
Why not target no inflation at all? Well, the big risk there is that we might slip into deflation, in which prices fall and the value of cash rises.
One effect of that would be to put the brakes on consumer spending, encouraging people to delay their purchases as long as possible while things get cheaper and cheaper. And that in turn would put further downward pressure on prices -- producing what is known as a deflationary spiral.
Japan's long economic slowdown of the 90s was made worse by periods of deflation, and the Great Depression was associated with a deflationary period too. We don't really want another of those -- though we might have been quite close to one recently.
It's harder for investors
The major problem for investors right now, of course, is that with CPI inflation running at 5.2%, we need to make an annual return of the same order just to break even and avoid losing money.
Still, if buying shares means we can beat other forms of investment, like cash earning a maximum of around 3%, at least our savings will be eroded less -- and with the number of depressed share bargains out there, I think we have a great opportunity to do significantly better than that.
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