Inflation measures the annual rate of change of the general price level in the economy. Inflation is a sustained increase in the average price level.

Inflation and the Price Level

When prices rise, the value of money falls. There is an inverse relationship between the price level and the internal purchasing power of money. When there is inflation money buys less in real terms. People can protect themselves against the effects of inflation by investing in financial assets that give a rate of return at least equal to the rate of inflation.

Hyper-inflation is extremely rare, although some countries experience it. In fact even when the rate of inflation is rising, the prices of some goods will be falling.  Deflation is also fairly unusual although some countries such as Japan and China have experienced price deflation in their economies in recent years.  In the United Kingdom, the main measure of inflation is done through the Retail Price Index.

The Retail Price Index (RPI)

The Retail Price Index (RPI) measures the average change in prices of a representative sample of over 600 goods and services. Each month, over 120,000 separate price samples are taken to compile the inflation statistics.

The index is weighted according to the proportion of income spent by the average household on categories of goods such as food and housing. These are periodically changed to reflect changing consumer spending patterns in the economy.   For example the weighting attached to food has fallen as average living standards have grown. The weighting attached to leisure services and transport has increased because these categories of spending have a relatively high income elasticity of demand.

RPI WEIGHTS (%)
Food 13.6
Catering 4.9
Alcohol 8.0
Tobacco 3.4
Housing 18.6
Fuel & Light 4.1
Household Goods 7.2
Household Services 5.2
Clothes 5.6
Personal Goods 4.0
Motoring 12.8
Fares 2.0
Leisure Goods & Services 10.6

Underlying Inflation (Rpix)

The underlying rate of inflation, known as RPIX, was originally set a target of between 1-4%. However, the Labour Government's target is for an average of rate of growth of 2.5% over the duration of this parliament which ends in 2002. Inflation is allowed to move between 1% either side of the 2.5% benchmark.  The Bank of England has been given the responsibility for meeting the inflation target. The chart below tracks  RPIX also known as underlying inflation for the UK since 1988.

The calculation of the RPIX is similar to the RPI, but excludes mortgage interest payments. This is because when interest rates are increased to control aggregate demand and inflation, the immediate effect is to increase mortgage interest payments and, therefore, housing costs.

As housing costs are a significant component of the RPI (see the table above), inflation is artificially increased. Thus the very policy adopted to tackle inflation actually creates a greater problem in the short run, and explains why the Government discounts this component of the RPI.

RPIY Inflation

RPIY, or the core rate of inflation, excludes indirect taxes and the council tax on the inflation rate. By stripping out the effect of these taxes, the Government can establish the core change of prices within the economy. Cynics would argue that it is just another way of reducing the headline rate.

A new measure of inflation has recently been introduced by countries within the European Union. This is called the harmonised index of consumer prices (HICP) and is meant to provide a standardised measure of inflation for each member nation of the European Union.

Other Measures Of Inflation

Input cost inflation measures prices paid by firms for raw materials, components and fuel. However, it does not include labour costs.  Over recent years the prices of essential inputs have stayed fairly low. Indeed the rate of input price inflation has been negative for a long period (see chart below). This has helped keep cost-push inflationary pressure under control.  These are measured separately by Unit Labour Costs (ULCs) which are calculated by dividing total labour costs by output - to give the labour cost per unit of output.   A common misconception is that a rise in wages or average earnings immediately places upward pressure on producer prices. This is not necessarily true, since rising earnings may be offset by an equivalent increase in productivity with ULCs remaining unchanged

.

The prices at which finished goods leave the factory is measured by the Producer Price Index (PPI). The PPI is also a good leading indicator of the RPI.

Further Reading

Base Rate Changes
Changes in the base rate since May 1992.
Yields on British Government Securities
Data going back as far as 1700.
Inflation data (Excel spreadsheet)