I | a-zofinequality

Inflation

Inflation is an increase in the general price level in an economy. It is typically measured using a representative basket of goods and services purchased by a typical consumer: the rate at which the cost of that basket rises is the official rate of inflation. Inflation erodes the purchasing power of currency as an increase in the general price level means that a pound (or dollar, or euro, etc.) affords less. Inflation can be contrasted with deflation which is a fall in the general price level and which causes currency to appreciate in value [1].

The impact of price levels can be considered by distinguishing between what economists call “nominal” and “real” values. For example, a worker’s nominal wage is how many pounds they are paid while their real wage is how much purchasing power they actually have after adjusting for inflation (or deflation) [2]. If, for example, a worker receives a 1% pay rise but their cost of living has simultaneously risen by 2% then their real wage has actually fallen by 1%; they can afford less they could before, despite the number on their paycheque being bigger. Likewise, distinctions are often drawn between nominal and real interest rates, nominal and real GDP, and so on.

Measures of inflation

There are three main estimates of inflation which are used in the UK: RPI, CPI and CPIH.

RPI (Retail Prices Index) is the oldest of the three measures and is now considered flawed and obsolete by statistical authorities. This is primarily due to methodological problems and complex mathematical issues which are beyond the scope of this topic, the upshot being that RPI does not always accurately reflect actual price changes. As a result, the Office of National Statistics (ONS) no longer considers RPI to be a valid “National Statistic” [3].

There are, however, more concrete differences between RPI and the other two measures. RPI excludes the highest-income households and some pensioners from its calculations. It also includes housing costs including mortgage payments, which CPI totally excludes and CPIH only partially brings back in [4]. As a result of these differences the rate of RPI typically exceeds that of CPI and CPIH, recording a rate of inflation about 0.5 to 1% higher [5].

Chart 1: average annual inflation rates in the UK since 1989 as measured by the different indices. Source: ONS [6].

Despite being considered flawed RPI is still recorded because it is written in to many laws and contracts. A House of Lords report accused the Government of “index shopping” and creating winners and losers in its decisions about which inflation-linked payments and prices to switch to the lower CPI and which to keep at the higher RPI. Benefits, tax thresholds, and public sector and state pensions were all switched to CPI in 2011 meaning they are increased at a lower rate; meanwhile, inflation-linked Government bonds, student loan interest rates, and rail fares are all still linked to RPI [7].

CPI (Consumer Prices Index) is a newer measure which is considered to be a better estimate of the actual changes in the prices of consumer goods and services. It also benefits from being in line with international standards which makes cross-country comparisons easier. However, a key flaw with CPI is that it does not include owner-occupiers’ housing costs at all which led to the creation of CPIH.

CPIH (Consumer Prices Index including owner-occupiers’ housing costs) is considered “the most comprehensive measure of inflation” by the ONS. It is simply a modification of CPI which includes owner occupiers’ housing costs, i.e. the costs of owning, maintaining and living in one’s own home including Council Tax [8]. The cost of actually purchasing a house is excluded, unlike RPI which at least partly accounts for this in the form of mortgage payments, so only rental and occupation costs are actually accounted for. This is justified on the basis that buying a house is an investment in an asset as well an acquisition of somewhere to live and the index is meant to be limited to consumption of goods and services, however it does seem remarkable that the biggest expense that most households are likely to ever face is excluded from the most highly-rated estimate of inflation [9].

Wages, consumer prices and asset prices.

If you just look at the official rates recorded over the past few decades inflation appeared to have been largely tamed (until recently...). Since the early 1990s inflation, whether recorded by RPI, CPI or CPIH has largely remained near the Bank of England’s 2% target [10], rarely exceeding 4% or falling below 0 (see Chart 1). By historical standards this was an era of low and stable inflation, worlds apart from the 1970s and 1980s when inflation rates regularly exceeded 5% or even 10% or the time of the gold standard when dramatic fluctuations between high inflation and high deflation were common [11].

This does not necessarily mean, however, that it was an era of affordability and a reasonably low cost of living. For two key reasons, recent years have seen many people struggling to get by despite the apparently low rate of inflation:

Firstly, for the average worker even these relatively low levels of consumer price inflation have been impactful because of sluggish wage growth, especially since the 2008-09 financial crisis and recession. According to the Resolution Foundation, real wages fell by nearly 7% between 2009-2014 and grew by just 0.7% annually from 2014-2017 [12]. This means that even relatively low inflation has been eating away at the typical worker’s paycheque and leaving them with reduced purchasing power.

Secondly, while consumer price rises may have been relatively modest, the same cannot be said for asset prices. Following the nadir of the 2008-09 crash, while wages have struggled to keep up with even CPIH rates, the housing and stock markets boomed (see Chart 2). Would-be homeowners in England have seen the ratio of house prices to income from employment more than double over the past couple of decades of “low inflation” – from 3.54 in 1997 to 7.83 in 2019 [13]. While equity prices have cycled through booms and busts they have nevertheless tended to enrich shareholders over time, apparently unmoored from the stagnation felt elsewhere.

N.B. Around the time of publication - too recently to be fully reflected in these charts and this discussion - consumer price indices have risen steeply with measured inflation rising to 7% and expected to continue to increase to around 10%, according to the Bank of England's May 2022 Monetary Policy Report.

This disparity raises the question: should asset prices, especially house prices, really be excluded from measures of inflation? Net property and net financial wealth make up a combined total of 50% of the wealth of UK households, while investments including equities also make up a significant share of private pensions which account for most of the other half [14]. Asset prices soaring relative to employment income is a key driver of wealth inequality, simultaneously enriching those who already own assets and also making it more difficult for those without to acquire assets for themselves. The broader story of prices in recent years, therefore, is of most people struggling to keep up with increases in the cost of typical consumer goods and services and seeing property consistently becoming less affordable, all the while the wealthy enjoy tremendous rates of return on their portfolios. This is a story that official measures of inflation fail to depict.

Chart 2: CPIH, average wages, house prices and the FTSE 100 index since 2009; standardised so Jan 2009 values = 1. Sources: ONS [15, 16], Land Registry [17], Yahoo Finance [18].

The distributional impact of inflation.

Inflation does not simply result in everyone experiencing the same increases in the cost of living. Various groups are affected very differently, some are winners and others losers.

The wealthy vs workers: as described above, asset prices have risen much faster than wages over the past decade. This need not always be the case and certainly has not always been true to the same extent. During the postwar economic expansion, from the 1950s through to the 1970s, labour received a higher share of national income but that share has been declining since the 1980s across developed economies meaning increased returns to capital – assets – relative to labour [19]. So long as it is the case, however, the wealthy are effectively insulated against steady inflation by the fact that they own the assets which are increasing in price most rapidly.

High- vs low-incomes: more generally, consistent inflation depreciates the value of currency which means that those who can afford to invest in assets which appreciate in value over time have a great advantage over many working households who may not be able to do more than accumulate a bit of cash in a savings account. The large and generally rising up-front cost of purchasing property or investing in equities mean that these methods of insulating against inflation are less accessible to poorer households [20]. Furthermore, even just focusing on consumer price inflation, lower-income households tend to experience a higher rate of inflation because they have to spend a greater share of their income on necessities like food, energy and housing (including rent) which have tended to increase in price at a higher rate than overall inflation [21].

Debtors vs creditors: the depreciation of the value of currency means that inflation has an impact on loans, especially long-term loans: inflation reduces the real value of debt over time. This is obviously nice for debtors who find that their debts are effectively shrunk over time while frustrating for creditors on the opposite end of the bargain, and likely plays a big role in encouraging borrowing and growing indebtedness across society.

The distributional impact of this aspect of inflation is somewhat mixed: on the one hand wealthy individuals and large corporations who have easy access to credit are by far the biggest borrowers in absolute terms; on the other hand low-income and asset-poor households tend to have the greatest proportional debt burdens. The least wealthy 10% of UK households are the only decile who hold more debt than wealth in the aggregate [22]. Among the bottom 20% of working-age households by income nearly half were experiencing some form of debt “distress” as of 2017, including struggling with unsecured repayments, rent, or being in arrears [23].

This impact of inflation on debt is of course largely negated if debts are index-linked to inflation rates. Institutional investors such as pension funds can purchase inflation-indexed government bonds which offer a higher yield if inflation goes up [24]. Meanwhile, as mentioned above, student loan interest rates are also inflation-indexed so graduate debt burdens are not lessened by inflation.

The Government itself can benefit from inflation in this way given its very large debts. Relatively high rates of inflation along with robust growth in the postwar era helped the Government whittle away the debts it had accumulated during and after World War II when the national debt rose to over 200% of GDP; comparatively lower rates of inflation since the 1990s have coincided with the national debt trending back up [25].

Central bank price targeting.

Since the 1990s an increasing number of central banks have adopted inflation-targeting as a central objective of monetary policy, seeking to control price levels and achieve a consistent rate of relatively low inflation. Many of the world’s richest economies, including the United Kingdom, United States, European Union, Japan, Canada and Australia, have settled on targeting an annual rate of 2% consumer price inflation or something very close to it [26].

It is important to note that, especially for the early adopters, inflation-targeting was taken up with the intent of bringing inflation down and keeping it low. Scarred by the “stagflation” of the 1970s, the toxic combination of sluggish growth, rising unemployment and high inflation [27] as well as the early successes some central banks had in bringing price levels under control in the 1980s, central banks came to believe that explicitly targeting price levels would mean achieving lower rates of inflation than would otherwise be the case [28]. Inflation-targeting along with central bank independence may also promote government fiscal discipline by not accommodating expansionary fiscal policy and large budget deficits [29]. Some believe that democratic governments are strongly incentivised to engage in inflationary behaviour [30] – spending more and taxing less, meaning higher budget deficits and a greater quantity of money in the economy – so an independent and disciplined monetary authority is needed to counteract this.

Since the 2007-08 financial crisis the environment in which inflation-targeting takes place has been very different. Consumer price indices show inflation to be generally low and, if anything, many central banks are now concerned with trying to generate more inflation and push prices up to meet their mandates. More recent adopters of inflation targets have explicitly done so for this purpose: the Bank of Japan adopted their target of a 2% annual CPI rate in 2013 as part of a broad effort to get Japan out of its decades-long period of deflation and economic stagnation, believing that encouraging more inflation will help to stimulate growth [31]; similarly, the US Federal Reserve changed its target to an average inflation target of 2% in September 2020 with the expressed purpose of allowing inflation run above 2% for a while as the economy recovers from the Covid-19 shock, believing that trying to squash inflationary pressures too soon played a part in the sluggish recovery from the 2008-09 recession [32]. Meanwhile, democratic governments across the world tended towards adopting fiscal austerity and prioritising debt reductions in response to that recession, seemingly a counter-example against the idea that fiscal policy tends to be inflationary. The 2010s were a very different world in which governments tried to control spending and central banks were the ones trying to generate inflation in order to meed their objectives. In this new context it is worth re-evaluating those inflation targets and questioning whether central banks really ought to be tasked with creating inflation.

Why have central banks settled on relatively low but stable – and therefore persistent – inflation? Why 2% rather than 1% or even zero inflation, i.e. price stability? In the decades of high inflation such a debate may have seemed like pedantic quibbling – though it certainly still took place! [33] - given the overriding need to just bring inflation down, but from a contemporary perspective it makes a big difference. Thanks to the nature of exponential growth even just a 2% annual rate of inflation would mean prices doubling every 36 years; the value of a pound being reduced by more than three-quarters over an average lifetime [34]. Given the further context of sluggish wage growth, even relatively low rates of imposition are a costly imposition. This is the fundamental issue: whereas central banks acting to bring inflation down may have been a beneficial intervention, working to deliberately and directly try and push inflation up when it might otherwise be naturally trending towards zero is a whole other story.

There are a few reasons why central banks chose to target a low but positive rate of inflation rather than price stability, including pragmatic beliefs that it was more easily achievable and the notion that it gives monetary policy more room to manoeuvre before interest rates hit the zero lower bound [35]. However, the biggest reason is probably that central banks are fearful of deflation. Both the Bank of England [36] and the European Central Bank [37] explicitly state that they target 2% inflation, or close to it, in part to provide a buffer against deflation. This goal has largely been achieved, with the UK having not experienced any periods of sustained deflation since the 1930s.

Why are central banks fearful of deflation? At face value deflation – a general fall in prices meaning an appreciation in the value of currency – seems like a great thing! Things get cheaper and savers are rewarded with their money becoming more valuable over time. Deflation of consumer technology – cheaper smartphones, computers, TVs etc. – has been a great boon in recent years [38]. However, deflation has a distributional impact just as inflation does and not all the consequences of a general and sustained fall in prices would be great. Deflation makes the real value of debts appreciate over time which is painful for highly indebted households and businesses. It also tends to encourage people to defer spending and save their money since prices will be cheaper the more they wait, but if everyone does this it will lead to a fall in consumption which could possibly result in a recession and a rise in unemployment as businesses struggle to sell their stock and generate revenue.

How do central banks control inflation?

Central banks attempt to control inflation through enacting monetary policy – controlling the supply of money in an economy. For a given level of economic activity the size of the money supply is believed to dictate the price level; if more money is circulating and chasing the same quantity of goods and services, prices will be higher. Most money is created privately by commercial banks making loans so central banks enact monetary policy by shaping the behaviour of banks and other financial institutions [39].

The primary monetary policy is the central bank’s policy interest rate, called the bank rate or the base rate by the Bank of England. This is the rate of interest which the central banks pays to commercial banks who hold money in the form of central bank reserves. While only accessible to banks, changes in the base rate tend to influence commercial bank behaviours and are therefore transmitted across markets, raising interest rates when it goes up and lowering them when it is cut [40]. Therefore, a lower base rate tends to make borrowing cheaper and so expands the money supply, encouraging economic activity and/or inflation; a higher rate does the opposite. The central bank can also adjust regulations such as capital requirements and risk controls to shape how much and in what ways commercial banks and other financial institutions are permitted to lend which will also have an impact on the money supply [41].

When the base rate hits the zero lower bound and inflation is still below target, as has happened frequently since the 2007-08 financial crisis, central banks have to resort to unconventional monetary policies to achieve their mandates. Some, including the European Central Bank and the Bank of Japan, have experimented with negative rates, requiring commercial banks to pay to hold reserves with them [42]. The more common response, preferred by the Bank of England for example, has been to engage in “quantitative easing” (QE).

QE involves central banks trying to further decrease market interest rates by making large-scale asset purchases which tends to lower the interest or “yield” on those assets. The Bank of England has primarily done this by buying government bonds but more recently they have also been buying investment-grade corporate bonds [43]. The logic is that doing this replaces safe assets with cash which investors will want to reinvest in other financial assets. This rebalances investment portfolios towards somewhat more productive (but also riskier) assets and also increases asset values, making companies and households which hold those assets wealthier and more likely to spend [44].

QE therefore doubles down on wealth inequality and rewarding the wealthy by inflating asset prices. Studies on the distributional impact of QE by the Resolution Foundation [45] as well as the Bank of England itself [46] suggests that QE has indeed contributed to wealth inequality though it may have also moderated income inequality as, to the extent that it really has stimulated investment and economic activity, it has supported employment and wage levels.

Interestingly enough, huge rounds of QE do not have appear to have made much of an impression in consumer price inflation indices which have remained broadly low throughout, though perhaps a bit higher than they would have been without any QE. The following is speculative, but it is worth wondering: is the contrast between relatively modest consumer price inflation and much greater asset price inflation the product of a sort of disconnect between monetary policy and the broader non-financial economy? Central banks have made money very easy to come by in the financial sector with near-zero interest rates and direct cash injections in the form of QE so soaring asset prices should not be particularly surprising; employers and consumers, on the other hand, have been hit with a recession and fiscal austerity which, if they are not wealthy enough to share in the asset bonanza, means their budgets have remained tight. While the Bank of England is mandated to achieve a targeted level of consumer price inflation, their actions may in fact be primarily fuelling asset price inflation – potentially even risking future deflation from asset bubble bursts – while largely failing to transmit to the index they are meant to be controlling.

Alternative mandates.

Expand inflation measures: there is reason to be dissatisfied with CPI/CPIH as purportedly comprehensive measures of inflation. Their failure to account for asset prices may lead to them underestimating the real extent of inflation and causing central banks to miss – or even encourage – dangerous asset bubbles [47]. Perhaps new inflation measures should be produced which incorporate the cost of assets, especially housing. The Czech National Bank has created a broader measure of inflation which includes house prices to supplement headline CPI figures and portray a bigger picture [48].

Central banks might also be better off focusing in on the distributive impacts of inflation to a greater extent. Inflation exceeding wage growth ought to be a cause for concern even if inflation appears to be low. It may even be appropriate to target wages rather than prices, with an understanding that so long as wage growth does not significantly exceed real productivity gains they should not create inflationary pressures [49].

Zero inflation target/price stability: if central banks want to stabilise the price level why not stabilise it at zero? In the 1990s several central banks were at least willing to consider this as a desirable long-term goal of monetary policy [50]. Price stability over the long-run would make it much easier for people to plan ahead, changes in the relative prices of different goods and services would be more obvious, and there would be a greater balance between savers and borrowers meaning that consumption and indebtedness would be neither encouraged or discouraged by monetary forces. It is plausible that, in general, it would be easier for people to understand market information and make prudent decisions according to underlying economic rationale.

The risks of a zero inflation target have already been discussed above: if prices are stable there is a greater risk that any shocks could push the economy into a dangerous deflationary period. The loss of the gradually eroding force of inflation on wages and debts could put many businesses into more precarious positions, reducing overall employment. Whether the benefits of price stability would outweigh these risks is not obvious.

Looser/no inflation targeting: there are reasons to be sceptical of the extent to which central banks’ can control inflation. The disinflation of recent decades could also be explained by “secular” trends that have created an economic environment conducive to relatively low inflation, regardless of what the central bank does. Plausible explanations include the efficiency gains of technological advancement and globalisation making consumer goods and services cheaper and the impact of an ageing global population which tends to prefer safe assets and consume less [51].

Central banks are also not the only authority which can affect the price level. Governments can induce or limit inflation via fiscal policy – public sending and taxation can impact the supply and distribution of money – financial regulators, to the extent they are separate from central banks, affect banks’ willingness to create money via lending operations, even organised labour and business organisations engaged in collective bargaining can affect the price level via wages.

Perhaps central banks should adopt looser inflation targets, or even no target at all, and focus on preserving monetary and financial stability in a broader, more holistic sense? Working in concert with regulators, fiscal authorities and other important stakeholders, central banks could focus on tackling distortionary and destabilising trends such as asset bubbles, overly risky lending and excessive indebtedness which are likely to lead to substantial shocks to the price level and economic activity. Modest amounts of both inflation and deflation in line with market forces might be tolerable so long as neither leads into a runaway spiral and the price level remains broadly stable over the long run [52].

1https://www.investopedia.com/terms/i/inflation.asp

2https://www.investopedia.com/terms/r/realincome.asp

3https://www.ons.gov.uk/economy/inflationandpriceindices/methodologies/consumerpriceinflationincludesall3indicescpihcpiandrpiqmi

4https://www.incomesdataresearch.co.uk/resources/viewpoint/rpi-vs-cpi

5https://obr.uk/docs/dlm_uploads/Working-paper-No2-The-long-run-difference-between-RPI-and-CPI-inflation.pdf

6https://www.ons.gov.uk/economy/inflationandpriceindices

7https://publications.parliament.uk/pa/ld201719/ldselect/ldeconaf/246/246.pdf

8https://www.ons.gov.uk/economy/inflationandpriceindices/articles/consumerpriceindicesabriefguide/2017

9https://www.ons.gov.uk/economy/inflationandpriceindices/articles/understandingthedifferentapproachesofmeasuringowneroccupiershousingcosts/januarytomarch2020

10https://www.bankofengland.co.uk/monetary-policy/inflation

11https://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/1750---2003/composite-consumer-price-index-with-description-and-assessment-of-source-data.pdf esp. Figure 1

12https://www.resolutionfoundation.org/app/uploads/2018/10/Count-the-Pennies-report.pdf