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Economics: Very average

If a week is a long time in politics, a month is an eternity in economics.
Between the May and June meetings of the Monetary Policy Committee there was a
marked change in the financial climate. For months, there has been a clamouring
for lower interest rates to counter the likelihood of weaker growth and higher
unemployment. But then, almost out of nowhere, a new risk emerged – a risk that
seemed to worry the policymakers even more than a slowdown in activity.
Inflation was again top of the policymakers’ agenda and there was even talk of
interest rate rises.

Although the monthly meeting to set interest rates is the headline-grabbing
part of the MPC’s work, a much better insight into the Bank of England’s
thinking on the economy can be gleaned from its quarterly inflation report, the
most recent of which was published this May. Typically dry and cautious, the
report sets out its views on the outlook for spending, output, costs and, most
importantly, inflation. May’s report highlighted the impact of rising energy and
food prices on inflation, which led to a more pessimistic assessment of the
outlook for interest rates. The Bank admitted inflation, currently 3%, could go
to 4%, before easing back to the target 2%. Expectations of rate cuts have been
put on hold.

Across the EU and to a lesser extent in the US, inflation targeting underpins
central interest rate decisions, and so the measurement of inflation is crucial
not only to set an appropriate rate, but also to the general acceptance of the
policy stance. If monetary policy is going to be linked to inflation, only one
measure can used; a measure that must somehow reflect the ‘average’ household.
At the end of 2003, Gordon Brown announced the measure of inflation to be
targeted would be the EU’s harmonised Consumer Price Index (CPI) rather than the
UK’s own Retail Prices Index (RPI), used since the formation of the MPC in 1997.

In the UK, recent media focus on petrol and food prices has led to claims
that the official indicators are understating the impact of inflation on
household budgets and that, as a consequence, pressures on disposable incomes
are much greater. Such claims are right and wrong at the same time. They
highlight the difficulty the authorities face in having one measure of price
changes and one that somehow reflects what most people feel is happening to
prices.

Currently, around 120,000 price quotations are used every month in compiling
the index, covering 650 consumer goods and services collected in around 150
areas throughout the UK. The goods and services are grouped into 12 divisions
such as clothing and footwear, recreation and culture, and furniture and
household goods. Each of the 12 divisions is assigned a ‘weight’ or share of the
total index that reflects its relative importance in the average household
shopping basket.

This is probably the most contentious aspect of the system. The principal
source for the weightings is the Office for National Statistics’ annual
Expenditure and Food Survey, which tracks the spending of several thousands of
households giving a representative cross-section of the population. Food, for
example, accounts for 9.5% of household spending and therefore of the index.
Fuels and lubricants have a 3.8% weight. Care is taken to ensure that the
shopping basket is kept up to date and goods and services are regularly added
and dropped, but changes are only made annually. Clearly, if prices change at
different rates, so should the weights, but these adjustments are also only made
once a year. Around the middle of each month, price data on the 650 goods and
services are collected, the weights applied and the change on the overall index
calculated.

It is easy to see how the meaning of the numbers can be questioned. While
nobody suggests it is fiddled, the index is only an average and anyone whose
income differs significantly from the average will feel it does not reflect
their spending patterns and, therefore, their inflation. Someone earning
£100,000 a year, for instance, is likely to spend a smaller proportion of their
income on food than someone on £15,000. Surging food prices will, therefore,
affect them differently.

Second, the coverage of goods and services is not comprehensive. Unlike the
RPI, the CPI does not include council tax or a number of other housing costs,
which, for many households, is one of the largest items of expenditure. It also
means that, since the housing market was outside its remit, the MPC has been
targeting a measure of inflation that did not include a group of items rising at
double digit rates. Not surprisingly, RPI inflation has been higher.

Given the sensitivity of policy decisions to the inflation number, it is fair
to ask whether the authorities are tracking the right indicator. The answer is
probably that no single measure of inflation could satisfy all interested
parties, but still, only one can be used. As long as the limitations of the CPI
are understood, it is probably as good as any. It does no more and no less than
the name implies.

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