Economy & Inflation

Arcaine

I have seen several threads on inflation on the boards here and I would like to put my 2p worth in on the subject.

Firstly to get a grip on inflation we must define what it is, and there is the first problem.

Some may say it the decrease in purchasing power of the currency you hold, or the prices of good increasing over time.

There are several problems with this.

1) How can you create a representative basket of goods for the prices. Who decides? and can we trust the information they produce does not have a political bias? New products appear all the time. How can we determine what inflation is for a blu-ray player based on historical data?

2) Current inflation measures (RPI and CPI) do not take into account asset prices, such as houses and equities. Mortgage payments are in there, but as banks lend ever larger multiples on fixed rates, for longer periods the effect of huge increases in house prices are masked in current inflation measures. So houses can double in price with no effect on inflation. Should we add house prices and equities to the basket of goods? How do we cope with speculators?

3) Fails to take into account credit. If you or I want to buy a fridge then we can borrow to buy it. We borrow, increase the money supply, and create demand for the product, without affecting our other purchases

So the current CPI and RPI figures, in my view are fundamentally flawed and will not give an accurate view of inflation.

I like the following definition,

Inflation is increase in the supply of money and credit.
Deflation is decrease in the supply of money and credit.

Let’s put this in terms of what has happened over the last few years.

Asset prices and raw material commodity prices have been climbing for years, in fact most stand at the highest level ever (oil, aluminium, gold). Yet prices of most consumer goods and food have been steadily decreasing for years. Manufacturers have been getting more economic, keeping labour costs down by moving overseas and creating economies of scale. This has kept consumer goods prices stable for years. The underlying increase in material prices being masked by savings.
Asset prices have rocketed, houses in the UK have gone up 200% in 10 years, inflation figures state 30% over the same period, as we can guess the fuel for asset price increases has been cheap debt. This cheap debt has allowed people to keep up the demand for all things consumer as well as buy a house and the necessities they need.

In summary,

Price increases do not fuel inflation, growth in the money supply does.

So what happens now?

We are already seeing the changes now through the credit crunch. Credit is essentially being destroyed, as borrowed money cannot be paid back on housing that is falling in value. America is already in the first rounds of a deflationary correction. The credit crunch causes banks to become capital impaired, which in turn means they cannot lend any more money. People’s finances become squeezed, so they either borrow, or tighten the budget. If they are unwilling to borrow they go into recession, as consumers stop spending.

I hope the UK can escape the worst of it. But houses here too are overpriced, kept high buy banks willingness to lend and peoples ability to take on more debt. We are already seeing the change in lending conditions. Will sentiment change enough to start driving house prices down? Cheaper consumer goods may be coming to an end, savings from cheap wages abroad are getting less and the price of raw materials will start pushing prices back up. So will people want to borrow more to pay for this? I feel there are 2 extremes at the moment, keep spending, borrowing more and more to keep the manufacturers going until the system collapses under a mountain of debt that cannot be paid back, or let the system deflate now and let prices correct, unfortunately this will lead to those asset price bubbles collapsing along with yours and my home values, pension funds and probably a large recession. I really hope I am wrong and there is a middle road in there somewhere.

I would be interested to hear people’s views on the matter of inflation and the economy and hopefully we can get a good debate going. I always was told by my English teacher a quote was a good way of ending so here is one by an Austrian Economist.

"There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved."

Ludwig von Mises

john_s_2

I think the answers to a lot of your questions can be found here - it's a series of links to various guides the Office for National Statistics (ONS) provides to explain the CPI and RPI.

http://www.statistics.gov.uk/statbase/product.asp?vlnk=62

How can you create a representative basket of goods for the prices. Who decides? and can we trust the information they produce does not have a political bias? New products appear all the time.

I don't know much about the underlying methodology but I do know that the basket of goods is based on a Government Expenditure Survey (Expenditure and Food Survey I think it's called). This is a survey of private households throughout the country.

The ONS is being made independent soon (from Government), which should help allay any concerns that it is politically influenced. (That's the theory anyway... ;-)

I've seen the CPI/RPI get a lot of flak on here. I can only comment from my own personal use of it. I have kept a spreadsheet for about ten years that lists all the major expenditures I expect to have to make (new fridge, cooker, sofa, etc etc etc) in order that I may save a reasonable amount towards their replacement.

I've found that by bumping up CPI a tad (say half a %age point) the prices I use seem to keep pace with reality when I check every couple of years. (Don't forget that these sort of goods only make up part of the basket so you wouldn't expect them to mirror CPI.)

I can't make a completely fair comparison as my source for checking prices has changed over the years. It used to be the Argos Catalogue but now it's the John Lewis website :-)