The government underreports the rate of inflation. The true rate is running at around 7% a year, which means your cost of living will double over the next 10 years, which is just another way of saying that your wealth will be cut in half over that time if you don’t keep up with the real rate of inflation.
Skewing the numbers
The agreed standard across Europe for measuring inflation is the CPI, or consumer price index, which is designed to track the price of a typical basket of goods and services purchased by the average consumer. According to the latest release from the Office for National Statistics (ONS), the cost of living in the UK is currently rising at either 3.6% or 3.9%, depending on whether you like to use the CPI or the higher RPI. The truth however is somewhat different.
There are a number of ways in which the figures are manipulated to understate the true rate of inflation. These include:
- Substitution: Items that have risen in price are substituted for items that haven’t. For example, if the price of steak were to rise the consumers might switch to buying beef burgers instead. The CPI calculations would then also be reweighted towards beef burger. Once this reweighting had occurred, the increase in price will no longer show up in the inflation figures. The decline in living standards is ignored.
- Hedonic Adjustment: Hedonic adjustment, or hedonic regression as it is also known, is used to factor in improvements made to the quality of a product over time. This particularly applies to high-tech goods. Take a new model 27-inch flat screen television for example. The new set has a retail price of £329.99, but according to those that compile the consumer price index, the new set has improvements such as a better screen, and therefore offers the consumer more. After running the changes through a complex government computer model, they determined that the improved screen is valued at more than £100, and factoring that in, they conclude that the price of the television has actually fallen 30%.
- Excluding mortgage costs: Mortgage costs represent the biggest expense for many households, but are not included in the CPI.
- Excluding other costs: School fees, council tax, domestic help, and household insurance are all excluded from the CPI.
- Emphasising ‘Core’ measures of inflation only: The media and politicians often report only the core rate of inflation which is based on a reduced set of statistics that exclude the food and energy components of CPI. This helps keep reported inflation lower because food and energy prices are often volatile. This does however ignore the fact that consumers cannot go without food and energy.
What all this number tinkering means is that inflation is underreported by around 45%. Today the true rate at which our cost of living is rising is around 7% per year, something which is self evident to anyone that does there own supermarket shopping.
What a 7% inflation rate means
What the inflation rate really measures is the declining purchasing power of our currency thanks to the government’s propensity to print money.
United Kingdom M4 Money Supply 1984–2007
Source: wikipedia.org. Note: Amount in billions of pounds sterling.
As the supply of money in circulation increases so our pounds buy less and less.
To calculate the doubling time you simply divide the percentage growth per unit time (7), by 70. 70 being, 100 multiplied by the natural logarithm of 2.
70 divided by 7 = 10 years.
The bottom line
If inflation remains at 7%*, then over the next 10 years your cost of living will double. To express this another way: If your wealth/ savings are earning 0% then in 10 years time you will only be able to buy half as much as you can today.
* I think it’s unlikely that inflation will remain at 7%. On average over the next decade I expect it to be considerable higher.