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Posts Tagged ‘Compiling the CPI index’

Fuelling the absence of inflation

The latest inflation figures, as detailed in February’s Consumer Price Inflation Statistical Bulletin, show that the annual rate of CPI inflation hit zero in February. This is down from 0.3 per cent in January. While inflation is now well outside the 1-3 per cent target range that the Bank of England is charged with meeting, perhaps a more pertinent question is whether the UK is teetering on the brink of deflation – and the risks that may carry.

To get a better sense of the latest inflation picture we need to delve deeper into the numbers and look at the patterns in the prices that make up the overall Consumer Price Index. Interestingly, these shows that five of the 12 principal product groups that make up the index are currently experiencing price deflation.

As explained in Consumer Price Inflation: The 2015 Basket of Goods and Services, produced by the ONS, around 180,000 prices quotations are collected each month for around 700 representative items. These goods and services fall into one of 12 broad product groups. These include, for example, food and non-alcoholic beverages and transport.

The items included in each of the 12 product groups are reviewed once a year so that the chosen items remain representative of today’s spending patterns. A monthly price index is calculated for these 12 broad groupings, known as divisions, and for sub-categories of these. For example meat is a category within food and non-alcoholic beverages. The overall CPI is a weighted average of the 12 broad groupings.

The annual rate of CPI inflation in February 2015 was zero. This means that the price of the representative basket of goods and services was unchanged from its level in February 2014. As Chart 1 shows (click here for a PowerPoint of the chart), the annual rate of CPI inflation series goes back to January 1989 and this is the first time it has fallen to zero. Its average over this period is in fact 2.7 per cent. The recent fall is quite stark with the rate of CPI inflation in June 2013 close to the top-end of the Bank of England’s target range at 2.9 per cent.

Of the 12 product groups, five constitute 10 per cent or more of the overall weight of the CPI index. These weights are dependent on the relative level of expenditure comprised by each division.

Chart 2 shows the annual rates of inflation for these five groups (click here for a PowerPoint of the chart). The most heavily-weighted component is transport (14.9%), which includes the price of fuel and passenger transport. Here we observe deflation with prices 2.7 per cent lower year-on-year in February. This is the fourth consecutive month where its annual rate of price inflation has been negative.

The second most heavily-weighted component within the CPI index is recreation and culture (14.7%), which includes games, toys and audio-visual equipment. Here too we see the emergence of deflation. In February 2015 prices were 0.8 per cent lower than in February 2014. Deflation is most prevalent in the fifth most heavily-weighted component (11.0%): food and non-alcoholic drinks. The price for this division of the CPI was 3.3 per cent lower in February 2015 as compared with February 2014. In nine of the last ten months the price of food and non-alcoholic drinks, helped by aggressive price competition in the grocery sector, has been lower year-on-year.

February also saw a negative annual rate of inflation emerge for the first time in the CPI division capturing furniture and household equipment and appliances (-0.3 per cent). Further, miscellaneous services, which include personal care and personal effects (e.g. jewellery) saw an annual rate of deflation for the eight consecutive month. The annual rate of inflation for miscellaneous services stood at -0.4 per cent in February. However, February did see an upturn in price inflation for clothing and footwear with prices 1.7 per cent higher than a year earlier while the price of alcohol and tobacco was 3.8 per cent higher year-on-year.

The detailed inflation numbers do reveal the extent to which many CPI divisions are already characterised by deflation. It is interesting to note that in A Comparison of Independent Forecasts published monthly by HM Treasury, the forecast for the final quarter of 2015 is for the annual rate of CPI inflation to be running at 0.8 per cent. An important reason for this is that the effect of falling fuel prices from November 2014 will begin to drop out of the year-on-year inflation rate calculations. The removal of this effect should help to prevent the specter of deflation provided that peoples’ inflationary expectations remain anchored, i.e. exhibit stickiness. If these were to be revised down, however, this would further contribute to downward pressure on prices since input price inflation – including wage inflation – would again be expected to fall.

Articles
U.K. on Brink of Falling Prices as Inflation Rate Drops to Zero Bloomberg, Tom Beardsworth (24/3/15)
UK inflation rate falls to zero in February BBC News (24/3/15)
Britain sees no inflation in February for first time on record Reuters, David Milliken and Andy Bruce (24/3/15)
Inflation hits a record zero boosting household incomes Independent, Clare Hutchinson (24/3/15)
Inflation Hits 0% As Food Costs Fall Further Sky News (24/3/15)
Inflation falls to zero in February as Britain heads to deflation Telegraph, Szu Ping Chan (24/3/15)
UK inflation hits zero for the first time on record Guardian, Angela Monaghan (24/3/15)

Data
Consumer Price Inflation, February 2015 Office for National Statistics
Consumer Price Indices, Time Series Data Office for National Statistics

Questions

  1. Explain the difference between a decrease in the level of prices and a decrease in the rate of price inflation. Can the rate of price inflation rise even if price levels are falling? Explain your answer
  2. Explain what is meant by deflation.
  3. In what ways might deflation affect the behaviour of people? What effect could this have on the macroeconomy?
  4. Why do you think policy-makers, such as the Monetary Policy Committee, would be interested in the inflation rates within the overall CPI inflation rate?
  5. What factors do you think lie behind the fall in the transport component of the CPI?
  6. Explain why the rate of inflation would be expected to rise in the late autumn, a year on from when the transport component of the CPI began falling.
  7. Does the possibility of deflation mean that inflation rate targeting has failed?
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The inflation within inflation

In two recent blogs we have analysed the headache facing the Monetary Policy Committee, given the persistence of inflationary pressures in the UK economy, in deciding whether to raise interest rates. In Food for thought, Elizabeth Jones describes how, despite the weakness of aggregate demand, cost pressures have fuelled inflation while John Sloman in Time for a rise in Bank Rate looks at the difficult judgement call for the MPC in risking a marked dampening of aggregate demand by raising rates while, on the other hand, failing to dampen inflationary expectations by not raising rates. In this blog Dean Garratt analyses some of the latest inflation figures as detailed in the latest Consumer Price Indices Statistical Bulletin. In particular, he focuses on the inflation rates within the overall consumer price inflation rate.

You might be wondering what we mean when we refer to inflation rates within the overall inflation rate. In answering this we need to consider how the Office for National Statistics goes about estimating the Consumer Price Index (CPI) and the CPI inflation rate (further details are available in Consumer Price Indices – A Brief Guide produced by the ONS). In order to compile the Consumer Price Index (CPI), each month an organisation collects on behalf of the ONS something in the region of 110,000 prices quotations for around 560 items. But, the key point is that these goods and services fall into one of 12 broad product groups which are referred to as level 1 product groups. These include, for example, food and non-alcoholic beverages and transport.

The items included in each of the 12 product groups are reviewed once a year so that the chosen items remain representative of today’s spending patterns. Once the price information for our representative goods and services has been collected, the prices are compared with their levels in the previous January and the change recorded. These changes are then aggregated in both each product group and across all groups. The price changes are aggregated by weighting them according to the typical share of household spending that each good or service represents. This process is repeated each month in the year so as to always calculate the aggregate change in prices since January. The final step is to link the price changes with those from earlier years to form one long price index, both for each product group and for the overall shopping basket, so that at one arbitrary moment in time the index takes a value of 100.

Once we have our price indices we can calculate annual rates of price inflation. The annual rate of CPI inflation in December 2010 is recorded at 3.7%. This means that the Consumer Price Index was 3.7% higher in December 2010 than it was December 2009. Similarly, the annual rate of CPI inflation in November 2010 of 3.3% means that consumer prices rose by 3.3% between November 2009 and November 2010. Across 2010 as a whole the CPI rose by 3.3%, so in excess of the Bank of England’s inflation rate target range, and significantly up on the 2.2% across 2009. The Bank has a symmetrical inflation rate target of 2% plus or minus 1 percentage point (you may want to read more about the Bank’s Monetary Policy Framework).

Let’s look to delve deeper because price indices are also available for product groups at two lower levels known as level 2 and level 3 product groups. For example, from within the food and non-alcoholic beverages group there is a price index wholly for food and within this one for vegetables. Again annual rates of price inflation can be found for level 2 and level 3 product groups.

If we consider food and non-alcoholic beverages we find an annual rate of price inflation for December of 6.1%. This was its highest annual rate since May 2009. Across 2010 as a whole we find that prices rose by 3.4%, very much in accordance with the overall CPI inflation rate. Inflationary pressures within this category are not new with 2008 seeing prices rises by 9.1% as compared with 3.6% for the overall CPI inflation rate. Over the past 5 years, food and non-alcoholic beverage inflation has typically been running at an annual rate of 5% while overall consumer price inflation has been running at 2.8%.

If we now focus on food alone, we find an annual rate of food price inflation in December of 5.7%. While this is a little lower than with the inclusion of non-alcoholic beverages, it is nonetheless a full 2 percentage points above the overall CPI inflation rate. Across the year as a whole food price inflation comes in bang on 3% highlighting the extent of the inflationary pressures in more recent months. This, however, still falls some way short of the pressures seen in 2008 when food prices rose by 10.1%. If we drop to level 3 to focus on groups within the food category we find inflation rates for oils and fats of 11%, for fish of 9% and for fruit of 8.6%.

Within the 12 broad groups the highest annual rate of price inflation is currently to be found for transport where the annual rate of price inflation in December was 6.5%. Across 2010, transport prices rose by 8.3% which compares a tad unfavourably with the 0.8% increase seen in 2009. If we drop down to the level 3 groups within this category we can trace the source of the price pressures more readily. The cost of air passenger transport in December was up over 12 months by 13.5% and, you may not be surprised to learn, the cost of fuel and lubricants was up by 12.9%.

We finish by noting the only level 1 category to see prices fall across 2010: clothing and footwear. This product group saw prices fall by 1% in 2010. But, even here price pressures have emerged. Between April 1992 and August 2010 clothing and footwear consistently recorded annual rates of price deflation. Since September this has ceased with positive annual rates of inflation. The annual rate of inflation for clothing and footwear in December was estimated at 1.5%. Perhaps those socks in my bottom drawer really will have to last me just a little bit longer!

Articles
Inflation is a blip says Bootle BBC News (21/1/11)
Fuel prices could rise by 4p in April BBC News (22/1/11)
Paul Lewis: Why inflation is starting to buy BBC News (20/1/11)
High levels of inflation remains a worry for Beijing BBC News (20/1/11)
Inflation ‘biggest money worry for families’ BBC News (19/1/11)
UK inflation rate rises to 3.7% BBC News (18/1/11)
Inflation hysterics Financial Times (19/1/11)
Top investors raise alarm on inflation Financial Times, Richard Milne, Dan McCrum and Robert Cookson (21/1/11) )
Inflation hits 3.7% after record monthly increase Guardian UK, Graeme Wearden (18/1/11)
We knew inflation would be bad, but not this bad Guardian, Larry Elliott (18/1/11)
The mystery of clothes inflation and the formula effect The Economist (21/1/11)

Data
Latest on inflation Office for National Statistics (18/1/11)
Consumer Price Indices, Statistical Bulletin, March 2010 Office for National Statistics (18/1/11)
Consumer Price Indices, Time Series Data Office for National Statistics
For CPI (Harmonised Index of Consumer Prices) data for EU countries, see:
HICP European Central Bank

Questions

  1. Describe the process of compiling the Consumer Price Index (CPI). Are we comparing the cost of the same basket of goods and services across years? What about within a given year? (Further details are available in Consumer Price Indices – A Brief Guide).
  2. Explain the difference between an increase in the level of prices and an increase in the rate of price inflation. Can the rate of price inflation fall even if price levels are rising? Explain your answer.
  3. Why do you think policy-makers, such as the Monetary Policy Committee, would be interested in the inflation rates within the overall CPI inflation rate?
  4. What factors do you think lie behind the pressures on; (i) food prices; (ii) clothes prices; and (iii) transport prices? How would your answers help to inform how you would vote on interest rates if you were on the Monetary Policy Committee?
  5. The following are the consumer price index values for all items, food and non-alcoholic beverages, clothing and footwear and transport in 1988, 2009 and 2010. Use these values to calculate the percentage change between 1988 and 2010 and those between 2009 and 2010. Comment on your findings.
    All items: 1988= 63.5; 2009= 110.8; 2010= 114.5
    Food and non-alcoholic beverages: 1988= 68.2; 2009= 123.2; 2010= 127.4
    Clothing and footwear: 1988= 163.8; 2009= 79.6; 2010= 78.8
    Transport: 1988= 55.4; 2009= 112.7; 2010= 122.1
  6. How serious an economic issue do you think inflation is? Illustrate your answer drawing on real-world examples of the impact of inflation.
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