Today’s Low Prices Ease Yesterday’s Inflation

Professional economists continually strive to predict future conditions. While these trained analysts are interested in the big picture, everyday money managers must also account for economic trends – like inflation and other market realities. And since accurate forecasting makes for better budgets, staying ahead of economic movements can have a significant impact on personal finances. In order to predict where prices are headed, it helps to look at the pricing history of consumer goods and services.

Understanding Inflation

Inflation measures the rate of increase in the prices of things we buy. The Consumer Prices Index (CPI), for example, furnishes one measure of inflation. While the Retail Pricing Index (RPI) offers another method of tracking and comparing retail prices. Both scales look at the prices of hundreds of items consumers buy regularly, tracking changes over time. Expressed as percentages, a CPI bump of 4% indicates a corresponding rise in the price of goods and services, as compared to the prior year.

The RPI and CPI differ substantially in the way they represent inflation. Though based on roughly the same dataset, the two methods calculate inflation using different techniques. The RPI, for instance, includes mortgage lending data, which is not a part of CPI calculations. Invariably, the resulting CPI is lower than its corresponding RPI, for the same measured time period.

To calculate inflation, the indexes note prices of tens of thousands of consumer items, comparing them to prices twelve months prior. The scales also weigh the value of particular goods, assigning greater importance to certain items. As such, the resulting percentages represent not only how much things cost, but how much we spend in each category.

How it Impacts Consumers

One of the easiest ways to identify inflation is to track it at the supermarket. Out of pocket spending on food and other everyday purchases reflects your bottom line, so your true cost of living is directly tied to inflation. In 1914, a loaf of bread or kilo of potatoes sold for 1p. Today, the same buys run a pound or more, graphically illustrating the impacts of inflation.

Today’s UK shoppers are experiencing nearly unseen conditions at the supermarket. Heavy competition and a robust harvest last year continue to push food prices lower. In fact, grocery bills are nearly 3% lower than the same time last year. The resulting cost of living increase of only .3pc is unheard of. Prevailing low food prices are further supported by falling energy rates. As a result, UK consumers are feeling their take home pay going further than it once did. But inflation influences your personal economy in other ways too.

The CPI is widely used in government and industry, called upon to set policies and guide financial decisions. The rate of inflation provides important clues about the state of an economy, because sustained prosperity depends upon steady wage growth and inflation that is in-line with increasing earnings and production potential. It is such essential data, that the Bank of England uses it to set interest rates, impacting savings, loans and investments.

The Bank of England rate determines what you’ll pay for borrowed money. Mortgages and loans of all kinds are influenced by the base rate, which today lingers at historically low levels (.5pc). Adjustments to the rate are often designed to make specific corrections within consumer markets. Rapidly rising inflation, for example, is generally met with a rate increase. Making it more expensive to borrow money ultimately puts downward pressure on consumer pricing. When inflation slows to a crawl, on the other hand, an interest rate cut is intended to make a correction.

In addition to impacting loan interest rates, the Bank of England rate also provides the foundation for index-based investments. Employer benefits and pensions, for example, rise and fall according to the Bank of England rate. And even beyond these formal relationships, the rate of inflation holds influence over salaries, insurance costs, and countless financial interactions.

Although inflation is considered to be a broad economic indicator, its effects trickle down directly to your bottom line. UK consumers are facing the first period of deflation in decades, so their household incomes are stretching for greater spending power. The trend however, is gradual inflation and rising incomes, which lead to a balanced, sustainable economy. By all means, ride the wave of falling food prices and decreased energy costs, but prepare for a “correction” and subsequent inflation.