1.1 Prices, the Value of Money and Indexation
The prices of consumer goods and services affect us all. From our individual experiences of shopping we know that prices change and the popular view is that prices tend to rise over time. For some goods such as petrol and diesel, prices are particularly volatile, with rises and falls driven by the price of oil, which is sensitive to political developments across the world and other market factors. The oil price is an important economic indicator and changes are reported in the press along with their implications for motorists. Consumers who buy petrol or diesel regularly will be aware of the resulting price changes. For other items such as bread and milk, prices are usually more stable over time and changes are not so apparent or newsworthy.
Although the common perception is that, overall, prices go up, we as individual consumers cannot see the whole picture extending over the huge range of consumer goods and services on offer in the marketplace. A robust statistical treatment is the only way of knowing if, overall, prices are rising or falling. The Retail Prices Index (RPI) is one of a family of statistical measures that attempts to address this question. It is constructed by taking a basket of goods and services carefully chosen to represent the full extent of the products and services available for consumers to buy and tracking prices of the component items. Each month, prices of these representative items are captured across the UK in different types of store and from the internet. The proportions of expenditure on different types of consumer item are also measured, though less frequently, primarily through a household survey. The average price change from a given reference period (usually a calendar month) is calculated by adding together the prices changes of the representative items weighted by the proportion of household expenditure they, and the items they represent, take up.
The Retail Prices Index has been calculated on a monthly basis since January 1956 and shows how prices have changed each month from a reference period where the index value is set to 100. The original reference period was January 1956; it is revised from time to time with the current reference period being January 1987. A convenient way to report price change is to calculate the percentage change in the Retail Prices Index for each month from the same month a year ago; this is reported as the (twelve-month) “rate of inflation”. If we look at the average value of inflation as calculated from the RPI from January 1993 to October 2019, we find prices have risen on average by 2.8% a year, approximately consistent with a doubling of prices over 25 years. The popular perception that, overall, prices tend to rise is correct. Of course, price rises haven’t been constant over these 322 months. Although the average value of inflation is relatively small at 2.8%, it reached 5.6% in September 2011 and inflation was negative between March and October 2009, during the great recession. The all-time highest inflation rate for the UK, as measured by the RPI, was 26.9% which occurred in August 1975.
High values of inflation can be highly damaging and even modest values cause problems. This is clear to see from a simple example. Consider an annual salary of £26,416, which was the average annual regular pay before tax for Great Britain in September 2019 (ONS 2019a). We can say that this has a certain purchasing power, that is, we can buy a range of goods and services with it. With an annual inflation rate of 2.8%, after 5 years, the purchasing power of this salary would be £23,009 (at the level of prices when the salary was first measured). This effect of inflation is widely understood and governments and employers (usually) adjust benefits, pensions, salaries and thresholds to account for the effects of inflation. This process of adjusting financial quantities by a measure of inflation is called “indexation” and it seeks to maintain the value of money in response to overall price change.
From our position today, we mostly take the measurement of inflation and the important process of indexation for granted. However, reaching this position has taken over three hundred years of development.
1.2 The Road to Modern Inflation Measurement
Price changes and their potentially damaging effects were first studied at the start of the eighteenth century and by the 1830s a clear statement of the issues and a proposal for a remedy was made by the Scottish political economist Joseph Lowe. The remedy was the measurement of the general level of prices and its application to make adjustments to financial instruments. While recognising the problem and what would be needed to find a solution was clearly an important step, it would take another eighty years for such a measure to be put in place.
From the 1830s onwards, a number of insightful individuals overlapping the areas of Economics and Statistics developed both the theory and practice required to produce an inflation measure. While individuals and private organisations began the practice of collecting data on a limited scale, it became apparent that the resources of the state would be required to move towards a robust measure. The role of the state in inflation measurement developed from the 1880s, when the Board of Trade began the systematic collection of both retail prices of goods bought by working class households and the proportions of household expenditure taken up by various items. The first measure of the general level of prices was introduced at the start of the First World War as the Cost of Living Index relevant to working class households. As an inflation measure, it was in a basic form, but its introduction was a very important step.
The inter-war period saw little development of official inflation measures; it wasn’t until after the Second World War that significant improvement was made with the development of the Interim Index of Retail Prices and the subsequent introduction of the Retail Prices Index in 1956. The methodology and the extent of the data collection at this point produced what we can recognise as a “modern” measure of inflation. The following years saw a range of improvements with an expanded basket of goods and services and advances in methodology being amongst the most noticeable changes.
As well as these improvements in the construction of the RPI, so applications of an inflation measure gradually expanded beyond informing wage settlements to include the adjustment of benefits and pensions. Over the years, the uses of indexation have continued to grow so that very large sums of money are now involved in maintaining the purchasing power of wages, pensions, benefits and more complex financial instruments.
Beyond the increased use of the RPI for indexation, developments in economic theory through the 1970s led governments and central banks to adopt explicit inflation targets based on inflation measures in their role of managing the economy through the setting of interest rates.
1.3 Monetarism and Inflation Targetting
Monetarism is a school of economic thought that gained widespread prominence in the 1970s. It is concerned with the role of money in economies; it maintains that the supply of money in an economy is the main determinant of economic growth and the level of prices and that the main role of the state is to manage the money supply accordingly. Governments and central banks have developed policies to control the money supply and to try to ensure both steady economic growth and low levels of inflation, the most prominent of which has been the management of central inflation rates.
It seems intuitive that a zero level of inflation is best; this would require no indexation, and so no money input from employers and the government. However, economists argue that a small level of inflation is beneficial. A small level of inflation is associated with economic growth and a corresponding increase in economic output per capita, which is a driver of increases in wealth. Businesses can also benefit. With small levels of inflation, businesses can decide to either over- or under-compensate workers with wage rises to re-allocate labour to its most productive areas, thus a small amount of inflation can be thought to support the work of the “invisible hand” at work in the market economy.
In practice, governments or central banks with the freedom to make financial adjustments set targets for inflation. In the UK, the Bank of England adopted an inflation target after the UK exited the European Exchange Rate Mechanism in 1992. The target was set at 2.5% as measured by a variant of the RPI. In 1998, the Bank’s Monetary Policy Committee was given the responsibility for setting interest rates in order to meet this target as part of the process of the Bank of England becoming an independent institution. The inflation target became 2% in 2003 when the UK government switched the index used for targeting from the RPI to the CPI; the difference in the value of the target reflecting the difference between the RPI and CPI at the time. The current target of 2% is a value used by other countries as well as the UK (O’Neill et al. 2017, pp. 26–32).
1.4 The Uses of Inflation Measures
The first official measure of the general level of prices was produced at the start of the First World War. It was called the working-class Cost of Living Index. Prices were collected from retail outlets that “conducted working class trade” and the goods and services in the basket were considered suitable for working class households. With substantial price rises at the start of the War, the government was concerned that essential war work might be disrupted by industrial unrest. Wage boards, which considered the pay of workers, were encouraged by the government to use the Cost of Living Index as a basis for their deliberations. This was the first use of an inflation measure as a basis for adjusting wages and established the principle of the approach we still use today.
After the War, the index was used more widely, including for the adjustment of wages for public sector workers; it was estimated that by 1922, three million workers were covered by what were called “sliding scales” which linked pay to price changes as indicated by movements in the index. Under these arrangements, when overall prices fell, so wages were lowered. This led to the numbers of workers covered by these arrangements reducing over periods when prices were falling and increasing when prices were rising.
The high levels of inflation in the 1970s show just how imp...