retail price index (RPI)
The Retail Price Index (RPI) measures inflation in the UK. This official measure is calculated each month by taking a sample of goods and services, which the typical household might buy. Included are such items as food, heating, housing, household goods, bus fares and petrol.
Those items of spending that are the most important in the spending patterns of an average household are given a higher weight in the overall retail price index. Collecting information on prices for the RPI Every month, a civil servant will visit a number of shops and examine prices and record the details for the benefit of government statisticians.
These figures for retail prices will reveal the trend for prices over the previous month, but an annual rate is also published and it's this number which attracts the attention of the media, wage bargainers and policy makers who have to decide whether it's appropriate to increase tax allowances and state benefits to compensate for inflation.
These days, there are three measures of inflation which grab the headlines. They are:
1. The headline rate, known by economists as RPI, - the most prominent measure. All items in the retail price index are counted in this measure of inflation
2. The underlying rate, which excludes mortgage interest costs, the one favoured by the Treasury (known as RPIX) - this is the rate that is the subject of the inflation target
3. A more pure version of the underlying rate known as the core inflation rate, which excludes not only mortgage costs but also taxation (known as RPIY). This is favoured by the Bank of England
RPI WEIGHTS (%)
Fuel & Light 4.1
Household Goods 7.2
Household Services 5.2
Personal Goods 4.0
Leisure Goods & Services 10.6
HEADLINE INFLATION (RPIX)
UNDERLYING INFLATION (RPIX)
The underlying rate of inflation, known as RPIX, was originally set a target of between 1-4%. However, the Labour Government's target is for an average of rate of growth of 2.5% over the duration of this parliament which ends in 2002. Inflation is allowed to move between 1% either side of the 2.5% benchmark.
The Bank of England has been given the responsibility for meeting the inflation target. The chart below tracks underlying inflation for the UK since 1988.
The calculation of the RPIX is similar to the RPI, but excludes mortgage interest payments. This is because when interest rates are increased to control aggregate demand and inflation, the immediate effect is to increase mortgage interest payments and, therefore, housing costs.
As housing costs are a significant component of the RPI (see the table above), inflation is artificially increased. Thus the very policy adopted to tackle inflation actually creates a greater problem in the short run, and explains why the Government discounts this component of the RPI.
RPIY, or the core rate of inflation, excludes indirect taxes and the council tax on the inflation rate. By stripping out the effect of these taxes, the Government can establish the core change of prices within the economy. Cynics would argue that it is just another way of reducing the headline rate.
A new measure of inflation has recently been introduced by countries within the European Union. This is called the harmonised index of consumer prices (HICP) and is meant to provide a standardised measure of inflation for each member nation of the European Union.
OTHER MEASURES OF INFLATION
Input cost inflation measures prices paid by firms for raw materials, components and fuel. However, it does not include labour costs.
Over recent years the prices of essential inputs have stayed fairly low. Indeed the rate of input price inflation has been negative for a long period (see chart below). This has helped keep cost-push inflationary pressure under control.
These are measured separately by Unit Labour Costs (ULCs) which are calculated by dividing total labour costs by output - to give the labour cost per unit of output.
A common misconception is that a rise in wages or average earnings immediately places upward pressure on producer prices. This is not necessarily true, since rising earnings may be offset by an equivalent increase in productivity with ULCs remaining unchanged.
The prices at which finished goods leave the factory is measured by the Producer Price Index (PPI). The PPI is also a good leading indicator of the RPI.
A final measure of inflation is the harmonised index of consumer prices a standardised measure of inflation used to compare changes in the cost of living between member nations of the European Union. The chart below shows that UK inflation using the HICP measure has been below that of the average for the Euro Zone for some months now.
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