As individuals with life-savings behind us, we are undoubtedly the luckier ones. Luckier? Well not just luckier in most cases, prudent – yes, sensible – undoubtedly. Savers need to have earned more than they have spent over long time-frames to have arrived in their current position of strength. However none of us feel as strong currently as we did towards the end of 2021. Prices are running higher as investment values have gone lower. It seems to be an every dripping tap and could even make us question investment itself.
Why we invest
The definition of individual savings in economics text-books is “deferred consumption”. We exchange money earned for the goods and services we consume daily. The point seems pedantic, but in economics text books, life savings are simply a measure of things we haven’t consumed yet.
Deferred consumption could therefore be measured in time. For many individuals on this planet, some could measure their ability to cover the cost of future consumption as infinity. The billionaires of the world could never consume all they currently have saved – even if they live forever. Many millionaires have reached an age where they could never consume their own savings in goods and services over the balance of their lifetimes.
So why take investment risk? Why bother investing further if you have enough?
The answer of course is that the cost of consuming goods and services today is known, but the future cost is unknown. An educated guess would probably be higher prices next year. Over the medium to long term the rise in the price of real assets, like shares and property, has always outpaced inflation and therefore should allow us to purchase goods and services even if the cost of them rises.
The rise in the cost of goods and services is measured by The Office of National Statistics and published monthly. You would have had to have lived under a rock recently to not have heard that global inflation is currently on the up and reaching new records. There today’s blog is all about how inflation is measured.
Inflation ain’t what it used to be
Growing up, the measure was RPI – the good old retail prices index. I’ve blogged about it years ago. But it was decided that we needed harmony with European measures so CPI was born – the consumer price index. You can’t assess one against the other though as they are as different as chalk and cheese, but we can still see there is a difference. RPI is always higher.
| Measure | Rate |
| RPI | 11.1% |
| CPI | 9.0% |
What do I need to know?
Well, first of all we need to know what the numbers mean. Obviously they relate to the rise in prices. But…
- The rise in price of what?
- The rise in price since when?
- The rate of rise or the total rise?
- Is any rise a good thing or a bad thing?
- Who is doing the measuring?
- Is the measure applicable to me personally?
- Will this last forever?
- What can I or anybody else do about it?
Many of us have noted the rise in the inflation number without actually finding out the background – we know higher is worse because Governments are being forced to take drastic, expensive action. Action which has directly affected the current value of our life savings. So let me save you some time trawling around the .gov websites to give you enough answers to allow you to more fully understand the relevance behind those high, scary numbers.
In a Nutshell
Inflation is measured as the rise in prices over the last rolling 12 months. Imagine a conveyor belt with 12 boxes on it of various sizes. Every month box is added as the oldest box is removed. That oldest box taken off could be a smaller box than the one being added. This would send the average up. Conversely if the oldest box to be removed was a large one and the one to be added was a small one, the average would fall. Each month therefore still consists of 12 boxes, 11 of which were included in last months total. So a CPI rate of 9.0% means
“average things cost 9.0% more on average to average people today than they did last year on average”
Now that sounds a little airy fairy – and indeed it should, because it tells us very little about our economic position in itself.
What is being measured exactly?
Many, many things, every month with prices collected from individual shops and multi-nationals. There are over 300 categories and over 700 items assessed each month. They do however vary a little as some things like “furbies” go out of fashion as do “tamagotchis” and “fidget spinners”. I think you get the idea that the basket is an equivalent mix, not a constant set of items. And no, I’ve never bought any of those, which brings me to a couple of interesting points.
Who is it basket measured for?
“The CPI’s weights are based on the monetary expenditure of all private households in the UK, foreign visitors to the UK and residents of communal establishments such as nursing homes, retirement homes and university halls of residence”. So to be average you need to be a UK person living in a house, a residential home and a student residence whilst being a foreigner visiting the UK. All at the same time! Many of us fall into just the one category and so the “average basket of goods” is very misleading for many of us personally. Moreover many of us own our own homes, the cost of which doesn’t even feature in CPI. For something a little more applicable there is a further measure CPI-H.
CPI-H
Now this does include housing costs – but not in a way which chimes with many of us homeowners. CPI-H includes housing costs, but excludes mortgage costs. It is not a measure of how much it costs to own and maintain a home, and could not be farther from the truth for most of us. CPI-H is calculated on a “Rental Equivalence” basis summed up as; What would we achieve if we rented our properties out? and How much higher would that be this year over last? We don’t currently have any clients who rent out their main homes nor plan to do so. The measure does work for Governments though and it is their favoured measure, as the number it produces is usually lower the CPI alone. Currently it is 7.8% not a headline grabbing 9.0%.
We do need to measure the rise in prices, but as you can see the measure is not as applicable to us as it is to many others renting, studying and visiting the UK.
Have prices risen 9.0% this month?
No, prices are currently rising at a rate of 9.0% from where they started 12 months ago. If prices remain the same for the next 12 months the inflation rate will drop to 0%. Inflation measures the rate of change every month not the amount of change. Those 12 proceeding values are then annualised to give the figure.
If the rate was averaged over 24 months instead of just 12 months the current rate would be just 4%. The rate for the months 1 to 12 was just 1.6% and for months 13 – 24 it’s 9.0%. The rate varies often. Taking a 24 month view (not many do) would make more sense over this extraordinary 24 month period.
Base Effects
We have a sizeable base effect to take into account here. Base Effect means – if you start low enough, any subsequent rise can seem absolutely huge! Let me remind you of where we were just over 12 months ago. The blue touch paper had just been lit…
“Number 10 and Boris Johnson confirmed his roadmap for easing lockdown on 22nd February. Overall , the end of lockdown completely is scheduled for 21st June”
The rate of annual CPI as of April 2021 stood at just 1.6%. It reflected a period where the only party in town seemed to have been at 10 Downing Street according to the main stream media. Remember not eating out, no hotels, no gyms, no holidays, not much underground or trains or flights? In short we have gone from a period of not much consumption to a period of fill your boots! Unsurprisingly prices have shot up from this low base as consumers chased the same goods and experiences, where supply lines were broken and individuals were working from home. Remember oil hitting a negative price a year ago? Many have forgotten you couldn’t give the stuff away in the US last April. You had to pay to take it off your hands! Any rise from a negative is a huge base effect over the following 12 months.
High inflation is a bad thing though. Right?
Well, yes it is bad. But we do need positive inflation numbers to function as an economy and a society. Prices must go up! Without prices gently rising, economies with stagnate and crumble. Goldilocks inflation is about 2% per annum in theory. If our expectation is that goods and services will cost less next year, why would we buy anything today other than just the essentials? All discretionary expenditure would cease, waiting for a better price next year. Businesses would go bust, there would be mass unemployment and years of depression before a balance was re-achieved. Inflation too high like now puts pressure on employers to increase wages, which increases the prices of the goods and services.
So what do I take away from this?
Well to be a long-term investor we must remain optimistic. Inflation will not remain this high forever. There is evidence from the US that the fear of the “R word” is driving workers back into the office now. They don’t want to be where the axe falls if redundancies become commonplace. Less flexibility has to be accepted, more showing up, visible hard work and higher productivity will keep your job in the future. There is evidence that businesses that cater to this uptick in workers returning are starting to benefit. Clothing sales, hotels, catering and transport providers are all becoming busier once again. Consumers in the US are baulking at higher prices now, which should lead to lower prices shortly.
“Inflation is the rate of change in prices, not the rise in prices.”
Prices will probably remain at this level, but inflation will fall if prices don’t rise much further from here. The base effect of 12 months ago will eventually be played out and peak inflation will have been reached.
Obviously there is the ongoing war in Ukraine which will keep fuel and some food costs artificially high, however fuel and agricultural commodities are large but not the only components of inflation. So the expectation is higher levels (5%+) will be with us for a further 12 months. The BOE projections are.
| Date | Rate |
| Q2 2022 | 9.1% |
| Q2 2023 | 6.6% |
| Q2 2024 | 2.1% |
| Q2 2025 | 1.3% |
It is well above my pay grade to comment on how the BOE work out their projections and I have to say they have not been very accurate in the past, but there is further consensus in the markets to confirm these future projections.
In Conclusion
In my last blog I outlined how we savers have been drafted in to fight these high levels of inflation. Our spending confidence has been knocked as our current savings valuation has fallen from its previous peak. We now have less “deferred consumption” to put our hands on right now, but since we won’t be consuming it all right now, does any of this matter to us?
Hopefully you have added to your investor knowledge of inflation and can see the mechanics of how times should revert to normal. There is an online calculator on the ONS website which should allow you to work out your personal inflation level. I’ve given it a go and it is half an hour of my life I will never get back. Save your half an hour and do something more productive.
Basically the level of inflation matters the most to individuals with little wiggle room in their finances. The more income that is needed to cover basics like food, energy, rent and public transport, the higher the effect of high inflation. Those of us with savings can easily see this period through to a time when prices fall back a little and life-savings levels rise once again.
This week we have enjoyed rising prices for most of shares in our portfolio, with the exception of a few energy shares where windfall taxes have come to investors attention once again. It could be too early to call, but May could be where the long climb back starts.