Thursday, January 8, 2009

Real Cost of Living vs Official Inflation Rate

To those of us keeping a close eye on our finances, the official 3% inflation rate might seem a little short of the mark. It may well be above the Government’s target of 2%, but to most UK households, a 3% rise in average costs would be affordable, if a little inconvenient.

In reality, the UK has recently experienced some much sharper rises in costs of living that are putting many people under serious financial strain.

It’s clear that the official inflation rate does not tell the full story. For that reason, The Telegraph recently reported on the Real Cost of Living Index (RCLI): an unofficial inflation measure designed to map out how much more each year the average British citizen is paying out for their essential costs of living – those that are unavoidable without making significant lifestyle changes.

RCLI: how is it different to official measures?

The Real Cost of Living Index aims to give a realistic weighting to the essential costs of living, which The Telegraph says “provides a more realistic picture of costs faced by hard-working families”. In particular, this includes housing (i.e. mortgage/rent), groceries, utilities, transport and taxes.

The current RCLI rate of inflation has been measured at 9.5% - over three times the official inflation rate of 3%.

To date, the Government have relied on the CPI (Consumer Price Index) and RPI (Retail Price Index) measures of inflation. Both measure the change in prices of a vast range of goods and services (known as the ‘basket of goods and services’), intended to represent the average buying habits of the British public.

There’s a problem with this method: for your own rise in costs to mirror inflation, you would have to buy everything in the Government’s ‘basket’, in the right quantities. In reality, each individual is only likely to buy some of these.

Considering that a reasonable proportion of household spending is taken up by groceries – of which The Telegraph reported a 23% yearly rise in average prices – it could be argued that the 3% inflation rate proves that CPI doesn’t give a clear enough picture of how or where prices are rising.

Why would official inflation figures conflict with real-life experience?

It’s a matter for great debate as to exactly why the official inflation rate of 3% falls short of so many real-life experiences. One explanation is that CPI does not include council tax and mortgage costs – two major expenses to any homeowner. But RPI does include these, and even RPI inflation is only 4.2%.

Government inflation measures give different weightings to items according to the perceived importance to the average person’s budget. But the much higher RCLI inflation figures suggest that essential costs of living are not being weighted highly enough in the official statistics.

What’s more, the Government has increasingly included items in their figures that are known to be steadily falling in price – most notably consumer electronics. This, along with items that experience little or no change in price, may go some way to neutralising the effect of such large rises in costs of living. And this could make the inflation rate look unrealistically low.

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