Sunday, December 28, 2008

The Real Cost of Living ? and Why the Inflation Rate Tells a Different Story

It may well be above the Government?s target of 2%, but to most UK households, a 3% rise in average costs would be affordable, if a little inconvenient. To those of us keeping a close eye on our finances, the official 3% inflation rate might seem a little short of the mark.

In reality, the UK has recently experienced some much sharper rises in costs of living that are putting many people under serious financial strain.

It?s clear that the official inflation rate does not tell the full story. For that reason, The Telegraph recently reported on the Real Cost of Living Index (RCLI): an unofficial inflation measure designed to map out how much more each year the average British citizen is paying out for their essential costs of living ? those that are unavoidable without making significant lifestyle changes.

RCLI: how is it different to official measures?

The Real Cost of Living Index aims to give a realistic weighting to the essential costs of living, which The Telegraph says ?provides a more realistic picture of costs faced by hard-working families?. In particular, this includes housing (i.e. mortgage/rent), groceries, utilities, transport and taxes.

The current RCLI rate of inflation has been measured at 9.5% - over three times the official inflation rate of 3%.

To date, the Government have relied on the CPI (Consumer Price Index) and RPI (Retail Price Index) measures of inflation. Both measure the change in prices of a vast range of goods and services (known as the ?basket of goods and services?), intended to represent the average buying habits of the British public.

There?s a problem with this method: for your own rise in costs to mirror inflation, you would have to buy everything in the Government?s ?basket?, in the right quantities. In reality, each individual is only likely to buy some of these.

Considering that a reasonable proportion of household spending is taken up by groceries ? of which The Telegraph reported a 23% yearly rise in average prices ? it could be argued that the 3% inflation rate proves that CPI doesn?t give a clear enough picture of how or where prices are rising.

Why would official inflation figures conflict with real-life experience?

It?s a matter for great debate as to exactly why the official inflation rate of 3% falls short of so many real-life experiences. One explanation is that CPI does not include council tax and mortgage costs ? two major expenses to any homeowner. But RPI does include these, and even RPI inflation is only 4.2%.

Government inflation measures give different weightings to items according to the perceived importance to the average person?s budget. But the much higher RCLI inflation figures suggest that essential costs of living are not being weighted highly enough in the official statistics.

What?s more, the Government has increasingly included items in their figures that are known to be steadily falling in price ? most notably consumer electronics. This, along with items that experience little or no change in price, may go some way to neutralising the effect of such large rises in costs of living. And this could make the inflation rate look unrealistically low.

Are inflation figures transparent?

Some critics have suggested that items in the ?basket? may be chosen for political reasons, rather than for an accurate representation of costs of living. There are a number of reasons why this could be the case.

Steady inflation

In many ways, a low-inflation Government is seen as a successful Government. The last time the economy really struggled was under the Conservatives in the early 90s ? and this was cited as a major factor in their loss of power. 3% inflation is by no means a low rate of inflation, but it?s a lot better than 9.5%.

Risk of a downturn

On the other hand, announcing an official inflation rate of 9.5% could be devastating to the economy. In times of uncertainty, a large part of recovery is down to consumer and lender confidence.

High inflation means money is technically worth less ? so people are poorer, and spend less. If companies give pay rises in line with high inflation, the prices which cause inflation are sustained, and may continue to rise. If they reach a certain point too quickly, demand will suddenly fall ? meaning business are stuck with high costs that are not being met by demand, and may be forced to make cutbacks. If this results in above-average unemployment, companies are hit by a further reduction on demand, which could lead to further cutbacks ? potentially sparking economic recession.

The rise in costs of living may well be higher than inflation would suggest ? but the inflation rate affects consumer confidence. In this sense, an unrealistically low inflation figure could in fact save the economy from further damage.

Is it accurate?

Thirdly, a 9.5% inflation rate wouldn?t give the full picture. Yes, some of the most significant costs of living are rising at this rate ? but the costs of many other goods and services aren?t. For example, the average consumer does not need to spend 9.5% more of their disposable income on things like CDs, DVDs, books, trips to the cinema, and pints of beer than they did this time last year.

only then would it be clear just how much are costs are rising, where they are rising, and how much of a problem it is. With increases in essential costs of living varying so wildly from that of other goods and services, it might be more accurate to release different figures for different areas of the economy ? together and measuring the average rise in costs isn?t accurate enough?

With that in mind, could it be that grouping a ?basket of goods and services?

Regardless of whether they publicly acknowledge it, the Government may well take a 9.5% rise in these costs very seriously. It measures costs which have a huge impact on how much we have left as disposable income. However inflation is measured, the Real Cost of Living Index is an important figure.


Lola December 29, 2008 at 3:14 PM  

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