Category Archives: Inflation news

Wages appear to beat inflation, but not when correctly lagged

The declining unemployment figures were such good news today, that most commentators appear to have overlooked reporting the data that ONS also published on wages.  These show average wages in February were up 2.2%, a figure significantly ahead of the latest published inflation figures (RPI=0.9%, CPI=0%). It is therefore very tempting to think wages are now increasing much higher than inflation and that the slack in the economy may have been extinguished. As ever with statistics there is much more to this than first appears. Although wages have picked up in the last year, workers have probably not yet negotiated better deals than inflation.

The complexity comes about because the wage bargaining process takes time and therefore has used a historical inflation benchmark as its reference point. The process of deciding on wage increases through to their implementation can take companies three months (or in the case of the public sector, more than double this time). For example it is likely that many of the wage increases included in the latest data today were actually decided looking at inflation figures from last autumn. It is therefore important to look at a lagged indicator of inflation in comparison to the ONS wage data.

The chart below therefore compares the rises in wages published by ONS with a lagged inflation figure. To make the data comparable, I have lagged inflation by six months, i.e. the latest wages figures (February 15) are being compared with what inflation was like in August 14. You can argue over the precise lagging, but this seems to fit the data quite well.

For inflation I have taken RPI as this most accurately reflects price rises experienced by people (see here for problems with CPI). RPI is also the main benchmark used in the private sector still.

wages v inflation

What is interesting about the graph is it shows that in “normal times” – say in the 4 years prior to the 2007 recession, wages exceeded RPI inflation by about 1% . This is in stark contrast to the first four years of the collation (2010-2014) where they lagged RPI by an average of 2.4%.

All this started to change about a year ago. Since then, wages have started to catch up the lagged inflation measure. It remains to be seen if they manage to exceed it longer term. There are two scenarios here.  The first assumes the slack in the economy has been used up and we return to normal 1% premium i.e. point A by the end of year, i.e. wages about 2% up in December 2015.

The second is that the latest data is somehow more of a pre-election effect brought about by a short-term borrowing and housing stimulus. In which case wage rises may decline back to near-zero levels by the end of the year as the impact of recent headlines of zero inflation rates take their toll on wage bargaining. i.e point B.

However what is key to note though is that the simple graph published by ONS is implying that wages are exceeding inflation by nearly 2% is misleading. That is just wrong because of the lagging effects and also their usage of CPI which is always about 1% lower than RPI.

ONS wages

Inflation rate to go negative says BoE – how might that affect you?

The latest Bank of England Inflation Report supports what most people were thinking anyway i.e. that the recent decline in oil prices would create a period of near-zero inflation in the UK. They predict it might happen after the energy companies decrease their prices in March and so will appear in the statistics published on 14th April.

Disposable income up

The most important one is that it will increase disposable income. Estimates vary, but my calculations suggest that the decrease in petrol prices and fuel costs will put an extra £100 a month into hands of every household in the land. Not only does that create a great positive feeling for everyone but it will have knock-on effects on the economy. The BoE Report is predicting GDP growth of 2.9% for the UK in 2015.

Real wage growth – or maybe not

There is much talk about real wage growth returning but I don’t think this will turn out to be quite the case. The argument goes that inflation is now zero but wage growth is 1.7%, so real wages, after inflation, are increasing. But this calculation is flawed on a couple of key counts.

Firstly, it is taking the projected CPI inflation rate for April 2015 and dividing it by the estimated wage growth for October-December 2014, i.e. before the inflation rate really started falling. It has yet to be seen what wage growth will turn out to be in April 2015.

According to YouGov, consumer future inflation expectations are plummeting, as people see more and more headlines talking about deflation. Therefore workers are going to be in a very weak position when they argue for pay rises from now on. Indeed some companies are considering freezing prices or decreasing them as their costs of production have declined. I would not be at all surprised to see average wage growth return to near-zero levels by Q2 2015. Therefore the correct calculation of average wages rises less inflation all based on Q2 2015 data might well show them to be stagnant again.

Secondly, there is another major flaw with this argument. It is using CPI as they key measure of inflation. As I have argued elsewhere, CPI under-estimates real inflation in the UK by around 1-1.5%. Therefore real wages are continuing to decline in the UK, even when CPI is very low.

Thirdly, near-zero wage rises may well persist throughout 2015 and into 2016, as a non-inflationary mindset starts to set in. However by then even CPI will have started to rise again, as the one-off effect of the recent oil price decline is removed from the calculation. Moreover it is not impossible oil prices will recover towards $75 a barrel at some point in 2016 and this could well push CPI back above the 2% target again (and real UK inflation above 3%).

Will low oil prices reboot the UK economy?

The BoE is banking on the boost from lower oil prices helping boost the economy that it reaches escape velocity and the slack is removed allowing productivity and wages to rise. Let’s hope that rose –tinted view materialises. However it is not impossible that the decline in productivity growth is here to stay and wages will not take off. In my view they may well revert again to lagging the rises in CPI inflation and significantly real UK inflation rates.

Enjoy the £100 a month windfall while it lasts.

ONS proposal to adopt CPIH for inflation and to bury RPI

On the 8th January 2015, ONS published a review by Paul Johnson (of IFS) entitled: UK Consumer Price Statistics: A Review.  In it, Johnson proposes that

1. ONS should move towards making CPIH its main measure
of inflation.

2. ONS and the UK Statistics Authority should re-state its
position that the RPI is a flawed statistical measure of
inflation which should not be used for new purposes and
whose use should be discontinued for all purposes unless
there are contractual commitments at stake.

On the positive side, it is commended that ONS is having a discussion about inflation statistics. I agree with Johnson that it is complicated to come up with one measure and method that seems perfect. It also correctly highlights the limitations of CPI (or HICP – the Harmonised Index of Consumer Prices, as it was originally known). This measure was invented by the EU in 1996 purely as a method of comparing countries to determine their eligibility for joining the Eurozone under the Maastricht Treaty. It was never intended as a cost of living index that would be used by individual countries, as has now happened in the UK.

HICP left out everything to do with housing costs – purely for the reason that EU members could not agree on how to measure it. It did not use weights based on the average person’s spending as these surveys were inconsistent across nations but instead used expenditure weights from the national accounts. This meant it was biased towards the expenditure of the rich. For example eating out counts 10% in CPI but just 5% in RPI, whilst alcoholic drinks is reduced top just 2% in CPI as opposed to 6% in RPI.

It also used geometric means (see below) to combine together individual prices, as that method was coming in vogue then both for statistical arguments and also probably because it produced more consistent and lowers levels of inflation. This was handy to help members qualify under the Treaty conditions.

In 2003 Gordon Brown decided to make it the main inflation measure that the Bank of England targets. One can only speculate why, though the fact that it is normally around 1% lower than RPI could well have contributed to that decision. That would mean it would make it look like the UK was meeting the inflation target more often than we did. In 2010, CPI started to be use to index pensions and welfare payments – again ensuring that these would be lower.

Roll on to 2012 and ONS tried to convert using RPI to use geometric means. This would have saved the government £7 billion a year in gilt payments alone, which would have been very handy when the coalition was trying to trim the budget deficit. However the consultation failed. 406 organisations, statisticians and members of the public responded. Just two of the 406 supported the ONS’s plan to switch to using geometric means for all the RPI calculations. That was a massive rejection of the plan by those not involved in the ONS or the Consumer Prices Advisory Committee.

Having failed to win the consultation, ONS immediately declassified RPI as an official statistic, leading to many jokes about RIP RPI.

Obituary for RPI

Clearly this subject has not gone away and ONS was back this week with another set of arguments, this time to attempt to permanently kill off RPI. The main one is that the Carli method used to calculate some of the prices increases in it is no longer internationally acceptable. Carli is used where there is a wide range of prices being combined. It involves taking the change in price in each store and then averaging these changes (as opposed to working out the average price across all stores and comparing it to last month – Dutot method). The key issue with Carli is reversibility. If prices go up and then come back down to the same level, you can get hypothetically end up with a price index that doesn’t go back to 100 (and is higher). The fact that this virtually never happens in the UK as prices nearly always go up and that the whole index is not price reversible is ignored, in this theoretical argument.

Instead what CPI uses (and RPIJ) is a completely different type of mean score called a geometric mean – called the Jevon’s method. It has reversibility but comes with a couple of side-effects. Firstly it is a calculation that is so complicated that, in my view, fails a requirement of comprehensibility to the public. However more importantly, it nearly always produces a lower price increase than has been experienced by the general public in the shops. Statisticians dodge the latter by saying it is in fact estimating substitution effects. In their oft quoted example, they say that if the price of Romaine lettuce goes up, some people will switch to a cheaper Iceberg and Jevons takes this into account with its lower price increase.

However quite how a geometric mean, which multiply prices together and taking the nth root of them, was supposed to measure the psychological dilemma of substitution was never explained. But more importantly, if the price of Romaine lettuce has gone up, it has gone up and that should be reflected in the price index. If people decide they can’t then afford it, that is a completely different issue. Furthermore such substitution effects are already fully being factored into RPI/CPI with their annual change in products being reviewed. No further adjustment is needed.

Therefore contrary to Johnson’s report, there are actually quite a few reasons to stick with RPI, which avoids the problems of geometric means.  Using the Carli method to combine mean scores might have its issues but so does using Jevons. They are just different ones. To me, a simpler solution for a UK price index would be to adopt the same approach as Germany and Japan, that is to just use the simple bog-standard Dutot average which has fewer flaws. ONS might argue that there is too much price variation to do that, but they just need to tighten up on the items being checked and make them more consistent. Saying to their price checkers to go find say “any ladies blouse” is open to a wide range of interpretations (and prices) and is just asking for problems.

Johnson’s other main conclusion is that we should adopt CPIH as the UK’s main inflation statistic. I tend to agree with Shaun Richards that this is a complete embarrassment for the ONS.  Firstly there are so many problems with CPIH that even the ONS have declassified it as a national statistic. However more importantly it does not solve the key problems with CPI.

CPIH was brought in after the failed 2012 consultation. H stands for Housing and it includes what are described to be “Owner Occupier Housing” (OOH) costs. You might immediately think that means things like:

  • house prices
  • mortgage costs
  • stamp duty
  • ground rent
  • building insurance
  • maintenance
  • council tax
  • etc.

These are all included in the RPI measure and housing accounts for a quarter of the whole index weight, as they are so important in the nation’s spending habits. But no, in CPIH none of these are included. Instead it uses something called “rental equivalence” of the theoretical rent paid for an equivalent house as a proxy for the costs faced by an owner occupier. Not only is that a really odd thing to do, but it also only gives them a weight of just 15%. Even more strange is that this rental equivalence measure (whatever it is), always seems to end up with a very low number for inflation of 1% or less. Therefore even as UK house prices are growing at 8%, OOH is still just 1%.

CPIH

The impact of this is clear as the chart above shows. This means that far from CPIH helping to increase CPI because of higher house prices, it is actually serving to reduce CPI still further (by an average of 0.2% over the last 3 years).

My personal guess is that CPI already underestimates inflation by around 1-1.5% in the UK. See Chapter 6 of Inflation Matters book (or download the Lite version here for free). Changing to the current CPIH would make that 1.2-1.7%. Therefore if CPIH was 2%, true inflation in the UK would be around 3.5%.

I am reminded of the Economist headline a few years ago: “Lies, flame-grilled lies and statistics“. Also as they more recently summarised the issue as: “Statistical offices vary in their ability to resist political pressure”. Is the ONS finally beginning to crumble?