The Truth About Inflation

As the true extent of the havoc wreaked by Hurricane Katrina becomes clear and petrol prices here in the UK lurch towards £1 a litre, stock markets are being pulled in opposite directions. At a general level equities are being underpinned by the expectation that the Fed will not hike interest rates on 20 September. That's because US economic activity may slow on its own as a result of this natural disaster. Meanwhile, chances are that energy stocks will continue to thrive.

On the other hand higher petrol and domestic energy prices act as a "tax" on consumers, taking a chunk out of their discretionary spending power. This is bad news for mass market general retailers who will have to trim margins further to keep sales ticking over. But not everyone will be tightening their belts in the same way. In fact, goods and services sold to wealthier people tend to have greater pricing power. The rising cost of living affects some more than others and companies that sell luxury items stand to benefit.

Are the Government statistics telling the whole story?

Think for a moment, if you will, about how much your cost of living has gone up over the ten years. According to the Office of National Statistics, using the consumer price index, the Bank of England's new preferred target measure for inflation, prices have risen by 13.6% since 1996. Given that over this period household income has gone up by over 50%, living standards must have sky rocketed under New Labour.

But is this your experience? Ask anyone in a pub or on the golf course and his or her perception of inflation will be very different. Petrol prices are poised to go over £1 a litre, private school fees keep rising and annual health and general insurance renewals are invariably well above inflation as are our council tax demands. Meanwhile, it costs you an arm and a leg to eat out in an up-market London restaurant.

So why is there such a discrepancy between our perceptions and the government figures? Is it because those of us who moan about the rising cost of living spend our money on the "wrong things"? Or is it because government statisticians are pulling a fast one? Well I reckon it's a bit of both.

Take a look at the table below. It shows how much various items of expenditure have risen or fallen in price since 1996.

Item                       % change since 199

Liquid fuels                        +9

Car insurance                    +8

House repairs                    +7

Tobacco                           +7

Car maintenance                +6

Education                         +6

Domestic services              +6

Hairdressing                      +5

Health insurance                +5

Package holidays                +5

Household appliances           -2

Footwear                           -3

Clothing                            -4

Cameras, camcorders          -5

TVs, HiFi, DVD players         -6

PCs                                 -92

Source: ONS

Now let's consider two families, Family A and Family B. Family A lives in a large old draughty house in the country that's in constant need of repair and is heated by oil fired central heating. The house is very remote so the family runs two old cars. The children are privately educated and the family is covered by private health insurance. The most technologically advanced gadget in the house is an old TV often in need of repair. The family is not fussed by the latest fashions and spends little on clothes. They employ a cleaner and a gardener. Both adults smoke and their other indulgences include package holidays, eating out and a weekly visit to the hairdressers.

Family B, meanwhile, lives in the centre of town in a modern well-insulated house. Both parents cycle to work, while the children attend the local the state school. The family does not smoke and chooses not to take out health insurance. The house is packed with state-of-the-art audio visual equipment, PCs and household appliances and much of the family's shopping is done via the internet. Family B spends a lot on clothes but steers clear of designer lines. They do not go out to eat much and prefer to watch TV, DVDs and play on the PC.

No prize for guessing which family's cost of living has gone up the most! However the official figures exaggerate the scale by which Family B has benefited from the collapse in the price of manufactured goods. Government statisticians now use a controversial practice known as hedonics for adjusting the real price of goods according to the increased usefulness and pleasure the product gives to the user.

This goes some way to explaining why the price of PCs has fallen by over 90% since 1996. Let us suppose for the sake of illustration that in 1996 a state-of-the-art PC cost £500, today a PC with ten times the power and capability also costs £500, but this is shown up in the consumer price index as a fall in the price of computers. But I cannot buy a brand new vintage 1996 PC for £50 instead I have to spend the same amount of cash as before for a PC with more bells and whistles that I might need. I think you will agree that the basis of this adjustment is rather contrived. 

The Bank of England's targeted rate of inflation also underestimates changes in the cost of living because it doesn't make sufficient allowance for changes in housing costs. In particular, council tax is excluded from the measure. This item has risen on average by over 5.6% a year over the last 18 years compared with an average increase in the retail price index of 3.7% over the same period.

As the targeted measure of inflation underestimates the changes in cost of living we experience, it follows that the Bank of England is erring on the side of monetary stimulation. This is certainly the case at the moment with broad money growing at a double-digit rate which in turn is pushing up the price of virtually everything but imported manufactured goods and residential property.

The China effect on the British consumer

Indeed a clear pattern is emerging. Mass-market manufactured goods are getting cheaper and cheaper while the cost of services has been rising by nearly 4% a year since 1996. The emergence of China as a global economic power has exacerbated this divergence. China has pushed down the prices of all mass-produced manufactured goods. Remember, 15 years ago a toaster was a staple wedding present; now you can buy one for a fiver! At the same time China's explosive growth has pushed up the prices of goods and services it cannot produce or provide. This is not only raw materials like oil and copper, but also financial and legal services and luxury goods. Moreover the falling price of manufactured goods has released funds for British households to spend on services, pushing the prices of education, plumbers and gardeners higher.

And it is the rising prices of goods and services at the luxury end of the market that is most noticeable. For example, demand for up-market restaurants in London is causing menu prices to soar at an unprecedented rate. There are now four restaurants in the capital where a standard dinner accompanied by the cheapest available wine costs more than £100 a head. Another manifestation of there being plenty of money at the luxury end of the market is the prices at London auction houses. In the first six months of this year Christie's sold 178 works of art for more than $1 million, compared with 132 in the corresponding period last year, an increase of over one-third. It is clear that there is little belt tightening at this end of the market.

By Brian Durrant, Investment Director of The Fleet Street Letter.