Does the consumer price index adequately capture inflation? If you try to tell anyone in a supermarket today that inflation is growing at just 2.5 percent a year, the likely reaction is cynicism verging on outright disbelief.
The CPI is just an index, constructed from a large number of sub indices, each capturing individual price changes. The weights used to construct the series, coupled with what sub indices are included, have enormous influence on the final rate of inflation.
This point is amply illustrated when we compare the CPI with a much older measure of inflation - the retail price index. Since 1997, the RPI has consistently grown faster than the CPI.
Today, the divergence is around 13 percentage points. In practical terms, this means if we were to compare two individuals - one whose shopping basket was accurately reflected by the RPI and another by the CPI - then the RPI consumer would be paying 13 percent more for their basket compared to their CPI neighbour.
Housing cost is the major difference between the two indices. The RPI includes housing, while the CPI excludes it. What happens if we take housing costs out of the RPI? The divergence goes down, but the RPI is still considerably higher than the CPI. Over the last 10 years, the RPI has cumulated a four percent difference over the CPI.
Of course, removing housing costs from the basket is total nonsense. People need to live somewhere, and it costs something. If housing costs are rising, then other things being equal, people are getting poorer. Any meaningful inflation measure would properly reflect that development.
The Bank of England is currently using the CPI as their inflation target. However, the exclusion of housing costs has allowed it to portray the level of inflation as being lower than most people actually experience.
The Bank of England has also placed heavy emphasis on its core inflation measure, which excludes food and fuel. This measure is utterly meaningless. No one lives without food, fuel, or housing. So the Bank of England's perceptions of inflation are disconnected from the day to day realities of inflation. This has lulled the Bank into keeping rates low, and fueling inflation and the housing bubble.
It's about time that this foolishness was stopped. The Bank of England need to do two things. First, it must revise its inflation target. In future, it should target the retail price index and not the CPI. Second, it should be banned from ever mentioning core inflation again.
These two simple changes would go a long way to preventing a repetition of the housing bubble and maintaining price stability. Higher mortgage costs will be reflected in the RPI, and when credit begins to rise, the Bank of England would be obliged to raise rates. In the short run, as the bank raised rates, this would generate a slight peak in the RPI, as higher rates raised mortgage payments. However, over the medium term it would ensure greater price stability and help avoid dangerous asset price bubbles.
It will be a happy day when the Bank of England dumps the CPI. People might again believe in official inflation numbers, and the MPC might again begin to get serious about bearing down on inflation.