CPI, RPI and the true cost of clothing

Have UK clothes prices gone up or down over the last 10 years? Most people would assume that the answer to this would be simple, just look at inflation. But not all inflation calculations are the same, they can use different formulas to calculate price changes and, as a result come to different conclusions.

Most people know that the UK’s Retail Price Index (RPI) differs from the Consumer Price Index (CPI), as RPI includes housing costs in the form of council tax and mortgage interest payments, but the differences between the two indices are deeper than this. For example when you compare clothing and footwear prices over the last twenty years, both CPI and RPI show prices declining during the first ten years, but for the second ten years a clear divergence appears.

The reason for this disparity comes down to calculation method. RPI uses the ‘Carli’ formula for around 30% of the prices it measures (including clothing and footwear), a measure that has previously been criticised for introducing an upward bias to inflation data. But even the initial decline is questionable! The Bank of England (BoE) have stated that annual CPI inflation may have been underestimated by up to 0.3% a year between 1997 and 2009 as a result of seasonal sales for clothing and footwear which saw discounts being captured by the data, but not the recovery back to normal prices as the sales ended. This led to a change in methodology being introduced at the start of 2010.

With inflation at the top of the BoE’s tolerance threshold, the Monetary Policy Committee will need to make a judgement on how quickly they need to raise interest rates. Understanding these intricacies of inflation measurement is a critical part of their role.

David Hooker – portfolio manager. Insight Investment, a BNY Mellon company

Have UK clothes prices gone up or down over the last 10 years? Most people would assume that the answer to this would be simple, just look at inflation. But not all inflation calculations are the same, they can use different formulas to calculate price changes and, as a result come to different conclusions. Most people know that the UK’s … read more

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UK inflation in context: three key charts

The return of inflation has been one of the dominant themes since the start of the year. Economic data in Europe and the US have both surprised on the upside while in the UK fears of deflation, which were so much a part of 2016, now seem a long-distant memory.

This is borne out by the latest figures from the Office for National Statistics whose Consumer Prices Index (CPI) jumped to 2.3% in February, up from 1.8% in January. This breaches the Bank of England’s 2.0% target and the bank itself has said it expects inflation to peak at 2.8% next year.

Two things are at play here: first, sterling’s weakness since the Brexit decision has increased the cost of imports; second, the increase in commodity prices, particularly oil, has had a knock-on effect through the rest of the economy.

Meanwhile, even as inflation begins to rise, UK interest rates remain at an all-time low of just 0.25%.

As inflation rises, we believe the Bank of England will consider tightening monetary policy, which in turn would increase pressure on bond pricing, particularly towards the long end of the maturity spectrum. Now more than ever we think it makes sense for investors to consider inflation protection strategies for their portfolios to preserve the value of future cash flows.

David Hooker – Insight, a BNY Mellon company

The return of inflation has been one of the dominant themes since the start of the year. Economic data in Europe and the US have both surprised on the upside while in the UK fears of deflation, which were so much a part of 2016, now seem a long-distant memory. This is borne out by the latest figures from the … read more

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Heavy weather for BoE inflation forecasts?

Market pricing would suggest investors are anticipating a prolonged period in which inflation overshoots the Bank of England’s (BoE) inflation target. The BoE asserts any pickup in inflation is likely to be temporary. As market expectations and official inflation forecasts fall further out of sync, the reality that emerges will have significant implications for holders of nominal and inflation-linked bonds alike.

The BoE’s rate-setting committee, the Monetary Policy Committee (MPC), has been reluctant to increase official rates in the face of higher inflation, owing to what it considers to be temporary factors. And, for now, it can point to public expectations for UK inflation being relatively well contained. This is reminiscent of 2011, when the BoE “looked through” price rises at a time when commodity prices were soaring and value-added tax was being increased. Inflation, as measured by the consumer price index, peaked above 5% that year.

Holders of nominal bonds need to be certain that the current increase in inflation is being driven by temporary factors, as the MPC asserts. If the BoE’s assessment is flawed, its commitment to low inflation will be questioned for the second time in recent history. This would arguably have serious implications for holders of nominal bonds, more so than owners of inflation-linked assets.

David Hooker – Insight, a BNY Mellon company

Market pricing would suggest investors are anticipating a prolonged period in which inflation overshoots the Bank of England’s (BoE) inflation target. The BoE asserts any pickup in inflation is likely to be temporary. As market expectations and official inflation forecasts fall further out of sync, the reality that emerges will have significant implications for holders of nominal and inflation-linked bonds … read more

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Why not all inflation measures are created the same

Central banks have long adopted inflation targeting on the premise that low and stable inflation will promote long-term economic growth. But in our view there are inherent problems associated with inflation targets, particularly when it comes to deciding which inflation measure to use.

The Federal Reserve (Fed), for example, targets the price inflation measure for personal consumption expenditures (PCE) at 2%. Like most central banks, the Fed targets the core inflation measure, arguing that volatile factors such as food and energy prices should be stripped out.

But, what if core PCE is giving a misleading picture of inflationary pressures in the US economy? Each measure of price inflation has components that are weighted differently and the sensitivity of each to the business cycle can vary. Some sectors may also be more prone to experiencing large idiosyncratic shocks compared to others. Other forms of aggregation can be used, further complicating the picture.

The suggestion that the inflation target itself may be flawed is interesting, given the effort investors pour into dissecting every line of monetary policy communication from central banks for clues as to the next move in interest rates or, as the case has been more recently, unconventional policy settings. The issue reminds this fund manager of Goodharts law, named after Charles Goodhart a former advisor to the Bank of England who first opined in 1975 that “when a measure becomes a target, it ceases to be a good measure”.

David Hooker – Insight, a BNY Mellon company

Central banks have long adopted inflation targeting on the premise that low and stable inflation will promote long-term economic growth. But in our view there are inherent problems associated with inflation targets, particularly when it comes to deciding which inflation measure to use. The Federal Reserve (Fed), for example, targets the price inflation measure for personal consumption expenditures (PCE) at … read more

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King versus Carney: in a world awash with liquidity, inflation forecasting becomes less certain

The long-term effects of quantitative easing (QE), especially on inflation, are an unknown. With conventional policy we have a history to look back on. With QE it’s all new. There is no history. This means that while central governments may have got it right, the reality is no one can be sure.

Indeed, central banks themselves no longer seem confident what could happen. Consider their inflation forecasts. The first chart above depicts the Bank of England’s inflation forecast in 2005 under former governor Mervyn King. In contrast, a more recent prediction under the aegis of current governor Mark Carney shows a far wider range of possible outcomes. In a world awash with central bank-initiated liquidity the old certainties would appear to be breaking apart. It’s not an exaggeration to say Central Banks are not really sure of the implications of their actions – or whether they will create the right outcome.

David Hooker – Insight, a BNY Mellon company

The long-term effects of quantitative easing (QE), especially on inflation, are an unknown. With conventional policy we have a history to look back on. With QE it’s all new. There is no history. This means that while central governments may have got it right, the reality is no one can be sure. Indeed, central banks themselves no longer seem confident … read more

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A race to the bottom?

Central banks have engaged in unconventional policies since the onset of the financial crisis in the form of QE, long-term repo operations, funding for lending and, in the US, the Troubled Asset Relief Program. Central banks’ commitment to safeguard their respective economies should not be underestimated. However, it is unsettling to see monetary authorities continue to ease policy at a time when lower oil prices are expected to boost disposable incomes and fuel global growth. Policy error is an important risk to consider when investing and given the unprecedented action taken since the financial crisis, it is difficult to gauge its impact in the longer term. Should central banks misjudge the policy responses, inflation could run higher than expected.

David Hooker – Insight, a BNY Mellon company

Central banks have engaged in unconventional policies since the onset of the financial crisis in the form of QE, long-term repo operations, funding for lending and, in the US, the Troubled Asset Relief Program. Central banks’ commitment to safeguard their respective economies should not be underestimated. However, it is unsettling to see monetary authorities continue to ease policy at a … read more

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Breaking free of the ‘fragile five’ misnomer

India was previously plagued by a high fiscal deficit, bad policy choices, high commodity prices, an extended credit cycle, high inflation and a weak currency. Now it has a credible and strong-willed central bank, a reform-minded government, and commodity price falls which are very beneficial to its terms of trade. We are increasingly confident that some of the major blockages for reform are in the process of being dismantled, and the government has already taken some bold steps, such as removing fuel subsidies.

In a market context, India has moved from one of the ‘fragile five’ to being highly favoured among emerging market investors, and near-term valuation multiples have moved to reflect investor optimism. We anticipate that some investor fatigue will be felt; however, over the longer term, India still looks very attractive, and is in the early stages of recovery from a cyclical downturn. Hence, current valuations are likely to be underestimating the profit upcycle for years to come and we think India will be one of the strongest equity markets in the world over the next five years.

Rob Marshall-Lee – Newton, a BNY Mellon company

India was previously plagued by a high fiscal deficit, bad policy choices, high commodity prices, an extended credit cycle, high inflation and a weak currency. Now it has a credible and strong-willed central bank, a reform-minded government, and commodity price falls which are very beneficial to its terms of trade. We are increasingly confident that some of the major blockages … read more

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