This inflation change will hit house prices
A new way to measure inflation could stop future housing bubbles!
Perhaps the greatest economist of the 20th Century, John Maynard Keynes, once wrote: "By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens."
What is inflation? It is simply a backward-looking measure of the rising cost of living, usually expressed as a percentage change year on year. For example, if yearly inflation is 2%, then a basket of goods costing £100 a year ago now costs £102.
When inflation is positive, it means that -- overall and on average-- prices are going up. When inflation is negative, then this 'deflation' means that prices are falling. Simples, as our meerkat friends would say.
Why inflation happens
One reason inflation persists is rising demand for raw materials and natural resources pushes up the cost of these items. As a result, manufacturers raise the prices of their own goods to reflect increased input costs.
Another reason for inflation is higher wages. When workforces get pay rises, their employers often cover this extra expense by bumping up their own prices. Indeed, it's been said that "One man's pay rise is another man's price rise".
Curbing inflation
As inflation undermines and erodes the future value of today's money, most governments aim to keep it under control. They do this by giving their central banks the task of setting monetary policy to meet a pre-set inflation target.
For example, the Bank of England has an inflation target of 2% a year, based on the Consumer Prices Index (CPI) measure of inflation. In theory, when future CPI is expected to be above 2% a year, then the Bank will raise its base rate in order to suppress rising prices. If inflation is too low, then the Bank cuts its base rate so as to stimulate growth.
Unfortunately, the Bank of England has a truly terrible record of controlling inflation. Since it adopted its CPI target of 2% in December 2003, inflation has been above-target for 69 months out of 102. In other words, the Bank has kept inflation at or below target for less than a third of the time, thanks to a failure rate of nearly 68%. Oops!
CPI's biggest flaw
The biggest defect with the CPI measure of inflation is that it excludes all housing costs. Therefore, when house prices go up and/or mortgage rates and rents rise, this has absolutely no impact on the CPI measure. In effect, the CPI ignores our biggest cost of living, which I regard as completely crazy.
Had housing costs -- house prices, mortgage repayments, rents and Council Tax -- been included in the CPI measure from the Nineties, then inflation would risen faster during the property boom of 1996 to 2008. In this scenario, the Bank of England would have raised its base rate higher and faster, pushing up mortgage rates and snuffing out the huge boom and bust that took place during the Noughties.
A huge change to CPI
As the CPI almost always underestimates true increases in the cost of living, it is a deeply flawed measure. At last, civil servants and statisticians may have grasped this fundamental fault with the way CPI persistently underestimates the true cost of living.
Earlier this month, the Office for National Statistics (ONS) announced that it is issuing a consultation (lasting until the end of August) on a new measure of inflation to replace the CPI. This new measure -- possibly named CPIH (CPI Housing) -- would include housing costs in its calculation.
Were the Bank of England to switch to targeting CPIH, then it would have to take rising housing costs into account when setting monetary policy. Of course, as rents rise and mortgage repayments go up, the CPIH would rise faster than the CPI. In this scenario, the Bank of England would have to tighten its monetary policy faster by raising its base rate earlier and more steeply.
Harming house prices
Right now, we already have an inflation measure that includes housing costs, which is the good old Retail Prices Index (RPI). Despite the RPI being consistently higher than the CPI, it is no longer targeted by the Bank of England (but it is used to lift pensions, benefits and the like).
Nevertheless, if the Bank of England were to adopt the CPIH as its new measure of inflation and publish it from the proposed date of next March, then this would have a significant impact on future house prices.
As house prices and mortgage interest rates (or rents) go up, this will push up the CPIH faster. The Bank of England will then respond by raising its base rate, helping to keep a lid on future house-price bubbles.
Then again, all this lies some way off in the future, Right now, the base rate has been stuck at 0.5% a year since March 2009, a record low since the Bank of England was founded in 1694. With the UK economy still very week, the Bank is afraid to raise the base rate for fear of snuffing out recovery -- not matter how high inflation goes.
In summary, I think a switch to measuring future inflation using the CPIH is a great idea. By tightening monetary policy to snuff out housing booms, and loosening it to support weaker property prices, then this will have a stabilising effect on future house prices. About time, too!
More: Inflation basket: How Robert Pattinson and Apple affect our money | Fight inflation with a regular savings account
Most Recent
Comments
-
I don't recall house prices being any more stable in the days when RPI was used as the inflation measure... Would have been useful if Cliff had noted when this was (was it under Major, or under Blair?)
REPORT This comment has been reported. -
Henry-GBG said: "Misleading. Inflation is caused by increase of money or decrease of available goods. It is not caused by higher wages or higher commodity prices. The latter is an effect of increase in money." That's right. The government lackies at the BOE print phantom money out of thin air, and the currency loses its value. Quantitative Easing is an example of inflation. That means if the price of your house is the same as it was last year, your house has gone down in value. Unless you are getting a government superannuation, or you are on the Bureau, you can ignore the RPI and CPI. Any back street massage parlour is more straight than government statistics.
REPORT This comment has been reported. -
House price inflation, the actual rise in the cost of buying a house - the price, capital cost + interest, has never been included in any inflation index. RPI includes mortgage interest repayments, but even this is an artificial measurement because as the CPI was the target inflation index by which the BoE set rates never included any housing costs, IR's by definition were not going to reflect the real cost of living and undoubtedly contributed to the credit boom and financial crisis. The BoE supposedly controls the money supply through IR policy, but most of the credit, i.e. money within the system comes from the banks. The problem is that most of the money produced has tended to go into those areas of the economy, assets like property, where inflation isn't measured by any of the indices used by the BoE to control IR's and thus supposedly control price inflation! Official price inflation for most of the pre-2008 credit boom days was therefore mostly kept in check despite the boom in house prices and increased credit spending on the back of it. The inflation indices were clearly measuring the wrong things, but again this was by design because the politicians and bankers don't, or at least didn't, like assets especially property values, to be included. Feelgood factor I suppose. Others have mentioned how does inflation come about? It should be remembered that by design the economic and financial system is inflationary, in that the desire is to have some inflation, but not high inflation and definitely little or no deflation. If proof is needed of this you only need to look at IR policy since the financial crisis began in 2007/8, it is clearly reflationary, money printing, ignoring inflation. BoE expectation has always been that inflation will supposedly come down in 12-18 months time, meaning they are always reluctant to raise rates and adopt a wait and see approach. So, how does the BoE's remit to control inflation fit in with what they have actually done in the last 4-5 years? It doesn't, they have proved themselves to be inflationists operating first and foremost in the interests of the wider banking system.
REPORT This comment has been reported.
Do you want to comment on this article? You need to be signed in for this feature
28 June 2012