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!
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