For the last couple of years we have been posting our alternative inflation reports just after the inflation figures for the main G7 economies have come out.  However, for over six months a pattern has emerged: the UK now has significantly higher inflation than any of them. So this month we will use this report to flag up some issues for readers to have in mind next Tuesday when the figures on the latest installment in our national inflation fiasco are announced.

The rise in food and energy prices has been seen by all sides as having  ignited the political explosion that has rocked north Africa over the past month or so. However, it is worth recalling that the official recent inflation figure for Tunisia was only 4% and in Egypt it was only about 10 %, which is about half the rate it was a year earlier.

Price Explosions

These inflation rates seem minor by comparison to the 1970s when no such explosions occured. One must conclude that it is the background of slow income growth, and the fact that the prices rises have been continuous –  that is making this crisis so intense.

The Bank of England always talks of keeping on top of people’s expectations, and preventing an inflationary spiral from taking off.  However, this current spiral in food and resource prices is international, and it is this international spiral that has taken off.  So has not now the time come to re-think our policies ?  So as to gear-up the UK for riding out this storm and the others that will come along.

While it is international resource prices that are driving this spiral, prices originating domestically must fall back otherwise inflation will be higher than it need be. Things like housing costs will have to fall if we are to pay higher prices for food and energy. This can already be seen in the United States but is not yet happening here. In December inflation for US urban consumers was 1.5 %.  If you look in the set  of figures released with that December US figure you will see that with what the Americans call ‘shelter’ taken out of the index, the US inflation figure would have been 2.0% For Chicago, without shelter inflation would have been 1.7 % instead of just 1.2 %.

Housing costs falling ?

So the falling price of houses and their rental prices is holding US inflation down. For most of the post-war period,  US house prices have been on average 3 times Gross Household Income.  When they reached 4 times average incomes  in 2006,  the US inflation index brought that little housing boom to a sudden end. And prices are currently under 3 times income.

Germany is the other major country that has a history of  being tough on inflation.   A big part of their success also lies in holding domestic accommodation prices down. Germany has held house prices stable for decades. Against a background of steady income growth this has made home ownership increasingly affordable for more people over the last couple of decades. While in relationship to incomes house prices in Germany are not dissimilar to UK prices, that is a steady improvement in a country that had to build so much of its housing stock after 1945. Home ownership affordability is improving most in the small towns and rural areas unlike over here. Homes in big cities are still too expensive for many to buy.

The main reason why the Germans and US have been more effective than us in holding housing costs down is that their inflation indices are very sensitive to housing. They are a big part of the notional baskets on which inflation is calculated. Almost a quarter of the US basket represents the value of owner-occupied housing alone.  20% of the German Consumer Prices Index is based on housing. By contrast, in the UK no more than 10 % of the Retail Prices Index (RPI) represents the basic accomodation costs. And the RPI claims to include housing in a way that the Consumer Prices Index does not !  For the last year rents were just under 7 % of the index. But another 3 % covers Mortgage Interest Payments. (Despite these payments being more the result of bank base rate decisions than the housing market).

Flawed UK indices

Alcohol however, is 6 %  of the RPI index. See table 4.12  in the document here. There is something seriously wrong with how we have weighted the UK inflation indices.   In 2009 Alcohol was 6.3 % and Rent was only  6.2 % !  And alcohol always had been bigger in the RPI. When it was originally set up in the 1940s, a professor at the London School of Economics wrote to the Times and asked rhetorically – what sort of family spends more money on alcohol than on clothes. ?

This problem with the weights is a major reason why many have considered that the UK indices have underestimated inflation here for decades. If there is too much alcohol in the index there must be too little of other things. We have got the weightings wrong.

Putting the indices right.

The Statistics Authority has now told the Office for National Statistics (ONS) that owner-occupied housing costs must now be factored into the Consumer Prices Index. The ONS are looking at 2 different ways of calculating it, called ‘ Net Acquisitions’ and ‘Rental Equivalence’ . In the chart below they show how each of these supposedly different calculations would have registered inflation during a period now universally seen as when we suffered the biggest house price bubble in our history (The blue line).  And the indices under consideration are shown in green and purple in this complicated chart below.

This chart comes from a bigger paper that can be found here. It is evident that neither of these measures would have alerted us to the inflationary problem except for right at the end of the boom when the  original CPI index was indicating a problem anyway. These calculations are therefore not fit for purpose, if that purpose is detecting and heading off inflationary problems. From what we have shown above, it will also be evident that the problem is that housing clearly does not have sufficient weight in the current indices and that the weights need to be revised. We think it is reasonable to expect that housing should have a weight in the index not very different from that seen in the German and American indices.

We will be making this point to the ONS. We will also suggest that the development of indices based on specific regions and localities of the UK, and specific household types, could help a process of revision of the weighting systems that would make the national figures more representative. We have earlier emphasized the importance of having regional figures if housing inflation is to be proportionately recognised – and promptly so. The ONS has been told to look into the issue of regional indices by the Statistics Authority.

When the BBC anounce the monthly inflation figures they usually say that the RPI includes housing costs to explain the difference from the CPI. From what we have shown above it can be seen that that is an over-simplification. In giving the figures a coherence they do not otherwise have, it borders on misrepresentation. Sky tends to just say the RPI is a wider index. However, last month the BBC did at last refrain from their usual practice of bringing on a banker to tell us that inflation is not as important as it might appear. (To justify low interest rates to savers). Last month the BBC even had the TUC on to comment on the figures.

The poor media coverage of inflation in recent years is also due to the sort of consultancies the media rely on. One of the most high profile is Capital Economics, founded and led by Roger Bootle who came from the old Midland Bank.  Bootle, always tends to minimise the prospects of inflation, which in the UK has been above the government target of 2 % for most of the last four years. What is almost never mentioned is that Bootle published a book called The Death of Inflation. Nowhere in the book does Bootle address the questions of how we detect inflation. Indeed, he published this book in 1996 just before UK house prices took off again under New Labour and became a serious form of British inflation that squeezed the middle of the British income spectrum, to borrow Ed Miliband’s term, and created the Two Income Trap to borrow an American term. Whether Bootle is responsible for the poor media attention to inflation or just reflects it must be left to history to judge.

Andrew Lydon

LWM Regional Prosperity & Inflation Project