Investing Basics: Explaining inflation

Huge sums of money – ‘fiscal stimulus’ – have been poured into economies around the world to help companies survive the pandemic. An almost inevitable consequence is that inflation will creep up, as we are seeing – Christian Leeming explains what inflation is, how it is measured and whether it is always a bad thing.

What is inflation?

 
The simplest and most widely held definition of inflation is a rise in the overall level of prices for goods and services; households typically buy a range of products and services every day, the price of which may rise or fall by different amounts, so inflation is based upon an average across a wide range of products.

Some price changes will be more readily felt than others; food and energy for example, are more visible than others. Also the range of products and services consumed will differ between generations meaning that different groups of people will be affected differently by any given price change.

These differences cause debate about how inflation should be measured, so in order to get a broad idea of how the cost of living is changing, the Office for National Statistics (ONS) created an index based on a ‘basket’ of goods and services consumed by the average person.

A large number of price and spending surveys are carried out to ensure that the index reflects what people are actually buying, and that the changes in prices are correct.

These baskets are regularly updated and underpin the two major indices in the UK – the Consumer Prices Index (CPI) and the Retail Prices Index (RPI).
 

The difference between RPI and CPI

 
The key difference between these two inflation measures is that the RPI includes housing costs – mortgages -and CPI does not; thus RPI inflation is usually, though not always, higher than CPI.

The crux of the debate is that critics argue that the CPI understates inflation by leaving out housing costs, whereas supporters argue that housing is an asset rather than a product, and should therefore not be counted.

A side-squabble is that with many mortgages at a variable rate of interest, a rise in the interest rate to cool the economy, and bring inflation down, would actually raise inflation because it would push up mortgage payments, which is included in RPI.

The indices are calculated in a slightly different way; RPI is calculated arithmetically, while CPI is calculated geometrically.

CPI takes account of change in the consumption of goods that takes place when prices rise; because of the way clothing and footwear prices are calculated, they have a disproportionate effect, accounting for nearly two-thirds of the gap between CPI and RPI.

Government, unsurprisingly, plumps for CPI when updating welfare payments.
 
 

Problems with measuring inflation

 
The way in which inflation is measured is a further cause for debate. Some argue that the price of energy and food is so volatile that it should be excluded from the basket, resulting in the ‘core CPI’ index; others argue for all major items of spending to be included from price calculations, regardless of how volatile they are.

Another debate is how to properly measure changes in the quality of goods over time. £1,000 will buy you a better laptop this year than it would have a decade ago, and whilst most agree that there should be some adjustment to account for the improvement in quality, some argue that the methods used – ‘hedonic adjustment’- goes too far.

There is far from international agreement as it is alleged that some countries such as China and Argentina, lie about inflation; Argentina has effectively banned the production of independent statistics.
 

‘Real’ vs ‘nominal’ prices

 
Inflation references values in ‘real’ and ‘nominal’ terms; real values are those adjusted for inflation, while nominal – raw figures – are not.

It is an important distinction because some figures are quoted in mainly nominal terms, and others in real terms; economic growth is almost always given in terms of real GDP, whereas investment returns are usually given in nominal terms – especially in advertisements!

As an example if you have a savings account with an interest rate of 1% and annual inflation in both RPI and CPI terms is 2%, your interest rate is negative in ‘real’ terms – you are effectively paying to store your money, losing its real value or buying power. Eminent economist Milton Freidman argued that unexpected inflation was effectively a tax on saving.

The flipside of this is that inflation can be good news for debtors, reducing the real interest rate that they have to pay, and meaning that the value of their debt falls in real terms – although less beneficial if their earnings don’t keep up with inflation.

What causes inflation, and when does it become a problem?

1. Demand-based or ‘pull’ inflation

 
 
‘Pull’ inflation happens when a government or central bank stimulates the economy by increasing the money supply by cutting interest rates and lending money to banks in the hope that they’ll increase the amount of credit. Central banks can also ‘create’ money, which is then used to buy assets.

Either method results in more money chasing the same amount of goods, which should result in higher demand and higher prices.

In these circumstances, firms typically boost their output to meet the extra demand for their products, which increases growth and employment; however, companies catch up by raising prices, and workers demand higher wages, so the economy returns to the previous level of output, but with higher inflation.

The danger is that companies and staff become locked in a wage-price spiral because they fear inflation getting out of control; in this scenario, workers demand higher wages in order to keep up with rising prices, forcing companies to charge higher prices to keep up with rising wages.

At this point savers may take their money elsewhere, or head for ‘safe havens’ such as gold, which in turn can make it difficult for businesses to raise funds; in extremis this can lead to hyperinflation such as seen in 1920s Germany where money becomes worthless and people may switch to bartering.
 

2. Cost-based or ‘push’ inflation (sometimes ‘stagflation’)

 
 
Experts tend to focus on pull inflation because it is easier to predict, but inflation can also be caused by changes in the cost base – ‘push’ inflation.

This type of inflation is nearly always bad since it raises prices without boosting demand; consumers have to pay higher prices, but wages don’t go up to compensate because companies are being squeezed too, and often looking to lay people off.

Sometimes known as a ‘supply-side shock’, this can lead to ‘stagflation’, where both inflation and unemployment are high. A classic example of this is the Western economies in the mid-1970s when Arab countries raised oil prices and boycotted the West causing the oil price to go up four-fold in a month, and UK inflation peaked at 25%.

Changes to supply are another way to help the economy; low oil and commodity prices in the mid-1990s, combined with globalised labour keeping wages down, enabled economies to enjoy a combination of low inflation and strong growth.
 
 

What is deflation?

 
If inflation is too low or even negative you get deflation, which is where the process of cost-push inflation goes into reverse; if a fall in the money supply or a cut in government spending hits demand, fewer goods are bought and company profits are hit.

Because it is difficult to impose pay cuts, firms tend to cut output – they fire people and make less stuff; employment and economic growth fall, and prices and wages should eventually stabilise at lower levels.

Sometimes called an ‘internal devaluation’, this can be a long and painful process; whereas inflation taxes creditors by making their savings worth less, deflation hits debtors by driving up the real cost of servicing their debt.

The Great Depression was a period of deflation when the money supply fell by 25% in the US and prices fell by a third; unable to pay back their creditors, a wave of repositions and bankruptcies left millions out of work as unemployment reached a peak of 25% in 1933.