Chasing Inflation

As many readers will already know, inflation is “the change in prices for goods and services over time” or “a general increase in prices and fall in the purchasing value of money1,2. As often with dictionary definitions, the words don’t necessarily convey the true meaning of the term. So we’ll borrow our own example:

Do you remember eating Freddo bars when you were younger? When we were still young whippersnappers they cost 10p each. Imagine our dismay when we learned they now cost 25p. In 20-odd years, the price of a Freddo bar has risen by 150%. This is an example of inflation: the price of objects rises over time. Put another way, the purchasing power of your money falls over time. At the turn of the century £1 could buy ten Freddos, but now £1 will only buy you four.

Author’s note: we appreciate that inflation is a complex topic and a broad term with multiple different measures. We want this to be a widely appealing and informative article, rather than a slog through the economic principles and terms. For the sake of simplicity, we’ll be using the CPI(H) when we talk about inflation.

Inflation has a few relatives too: its diametrically opposed twin brother deflation, its boastful older sister hyperinflation (responsible for the $100 trillion banknote), its nefarious first cousin shrinkflation and its awkward second cousin stagflation.

In order to maintain our money’s purchasing power, we have to augment the value of our savings by earning interest. At minimum, we want the interest earned to match inflation. If inflation is 2% in a year, we want our money to grow by 2% over that year in order to retain our Freddo acquisition ability. Simple. If we can’t get the interest rate to match the inflation rate, something (e.g. 1% interest) is better than nothing. We can buy fewer Freddos than the year before, but perhaps more than the guy who had his cash stuffed in a shoebox. 

Global inflation rates in 2018. Adapted from source: World Bank.

Ideally, we want to outstrip inflation. We want inflation to be coughing on the dust thrown up by our runaway interest-generating wagon. If inflation is 2%, we want our money to be growing by three percent, five percent, ten percent; the more the better. You could pick any number here but ~5% is not a preposterous proposition. We want to be drowning in anthropomorphic frog chocolate bars come the end of the year.

Hopefully the above is not news to many of you. The more interest you can earn on your money, the better. Matching inflation should be the bare minimum goal; where should we set this low bar?

Requiem for a Savings Account

The rate of inflation varies geographically. With some exceptions, most people will only need to worry about the rate of inflation in the country in which they reside. If you did want to be more global in your approach, the average global inflation in 2018 was 2.75% 3

Let’s, however, set our minimum desired interest at the rate of UK inflation. The Office of National Statistics (ONS) is fairly consistent at publishing the most up-to-date rate. Though it does change month-to-month, for the last 12 months the highest inflation has been is 2% 4. Going back a bit further it’s been under 3% since 2012, but let’s use 2% as a current target. 

A savings account, you’d imagine, would be a reasonable place to start the search for an inflation-matching interest rate. Yet a quick look tells us that, at the time of writing, the best available instant-access savings account provides 1.05% interest. You could eke slightly more interest by locking your money in a notice (1.25%) or 5yr fixed-rate (1.8%) account, or gamble on the expected returns from Premium Bonds being greater than the advertised 1.16%. Other savings vehicles are not much better. The ‘regular savers’ offer a rate of up to 2.75%, though only on small sums. The realm of cash ISA’s (1.3%) and cash LISA’s (1.25%) isn’t much better. In desperation you turn to a current account and find that the best available offers 2%…on up to £1,500 for one year only 5.

UK Inflation(%) since 2010. Though inflation fluctuates, it has been under 3% since 2012. Source: Trading Economics.

It’s clear that the available interest rates from bank accounts aren’t up to scratch. Agreeably it may be appropriate to tolerate a degree of depreciation on small sums and/or over short time periods. Bank accounts do have other benefits, such as security and ease of access/transfer, but their utility as a medium-to-long-term savings vehicle is poor.

Our best laid plan to match inflation with interest has crumbled all too quickly. You might say that the interest offered is nearly there? Close enough to inflation? We’re not so sure….

Real inflation

What if the true, bona fide rate of inflation is higher than that published by the government? That is, what if our money is losing its purchasing power quicker than we suspect? Since first reading about the prospect in Andrew Craig’s ‘How To Own The World‘, this idea has gnawed at my brain 6

According to Craig,  there are “…ways in which governments ensure that inflation numbers end up always being lower than the true increase in your cost of living (so you think you are wealthier than you actually are…”. He goes on to describe these methods: substitution, geometric weighting and hedonic regression. It’s easy to scoff initially, the ‘tin foil hat’ radar pinging relentlessly. Yet a dig through the ONS site turfs up these terms. 

Substitution does occur and, if the new item is sufficiently different from the old item, its cost is ‘imputed’ (*checks thesaurus*: estimated). Re-weighting happens as well; between 2019 and Feb 2020 there was a 9% increase in the weighting of Recreation and Culture and a 6% increase in Education. Conversely, the weightings of the Food, Clothing and Transport sections were decreased 3% each. Hedonic regression is in the mix too, sitting alongside ‘option costing’ and ‘quantity adjustment’ as part of the package of tools used to make ‘direct quality adjustments’ 7.

We’re not suggesting that the whole thing is a sham, although the broad spectrum of uses for, and users of, inflation does provide a strong incentive to keep things neatly in check8. There have been examples of governments overtly manipulating inflation data (looking at you, Argentina9) but we’ve not seen any evidence that’s the case here.

Overall there is an element of subjectivity and estimation involved in the methods used. With enough slightly fudged numbers, be it deliberately or not, the end product could look rosier than it actually is. Even the ONS states that “The methodology for estimating the accuracy of the CPIH, CPI and RPI [measures of inflation] has not yet been fully developed…” 10.

The Freddo Index. Graph showing the actual rise in price of a Freddo Bar (blue line) compared with the expected rise in price based on inflation (green line). The price is rising faster than expected; does the published rate of inflation under-represent the true change in the cost of living?

The Freddo Index

We didn’t find an abundance of robust data reinforcing the claim that the true rate of inflation is higher than the published one. One report used its self-styled ‘essentials index’ to demonstrate that the cost of essential items was rising faster than inflation11. It found that the cost of essentials rose 7.8% in 2011 and 3.7% in 2012, even though the inflation rates for those years were 4.5% and 2.8% respectively. One US-based article implied that the rate of inflation must be higher than published because of the rising cost of a burrito over time, the so-called burrito index12

Let’s return to our old friend the Freddo bar. The ‘Freddo Index’, tracking the price of the snack over time, demonstrates how the cost of the wee chocolate bars has drastically outstripped inflation (see graph, above). The price grew 150% between 2005 and 2019, though inflation says it should have only risen ~40%. There was shrinkflation afoot too, as the weight of a Freddo was reduced from 20g to 18g between 2010 and 2011. Even if the price remained the same, you got 10% less chocolate bar in 2011 compared to 2010 and therefore had suffered from 10% inflation. It’s not just chocolate bars either, as you can see below.

Price of a pint of milk: actual (blue line) vs. expected (green line). Source.
Price of a litre of petrol: actual (blue line) vs. expected (green line). Source.
Price of a pint of bitter: actual (blue line) vs. expected (green line). Source.

These graphs all demonstrate that the cost of goods, from milk to beer to petrol, has often risen faster than inflation alone would dictate. Appreciably the determinants of the price of a good or service are much more complex than merely rising with inflation. The pattern, however, is concerning. It lends some soft weight to the idea that our money is devaluing faster than we realise. This begs the question: how accurate a marker is the published rate of inflation?

Investing: No Longer Optional?

We can’t keep up with inflation through traditional bank accounts and, adding insult to this injury, the actual rate of inflation might be higher than we think. Equally, the future rate of inflation is unclear, an unknown unknown13. There are arguments for both rising inflation and disinflation/deflation14. Whatever the rate, we need to be matching it to avoid our savings depreciating.

Investing, with its concomitant risks, is typically seen as a vehicle for the growth of savings. Now, it might be one of the few remaining bastions for those simply wishing to avoid the inexorable erosion of their purchasing power. Is the choice now between the risk of losing money by investing (but perhaps keep up with/outgrow inflation) or the guarantee of losing money by tolerating sub-inflation interest rates? It seems a damning state of affairs. Especially so for those with delicate financial positions who cannot tolerate the risk of investments losing their value; they are hemmed into a losing position.


Mr. MedFI

Deflation: at the end of the year my £1 coin buys 10 Freddos, not 4.
Hyperinflation: at the end of the year my £1 coin buys 0.0001 of a Freddo, not 4.
Shrinkflation: at the end of the year my £1 coin still buys 4 Freddos, but each bar is only half the size it was at the start of the year.
Stagflation, we realise, cannot be simply explained using our Freddo analogy and for this we apologise. 

1 – Inflation and Price Indices. Office for National Statistics. Available here.
2 – Lexico Dictionary. Available here.
3 – Inflation, World Bank Open Data. Available here.
4 – Percentage change year-on-year of the consumer price index (CPI) in the United Kingdom (UK) from 1989 to 2019. Available here.
5 – Money Saving Expert: Banking & Savings. Available here.
6 – Craig, A. (2019). How to Own The World: A Plain English Guide to Thinking Globally and Investing Wisely (3rd ed.). John Murray Learning. Available here.
7 – Consumer Prices Indices Technical Manual (2019), 9: Special issues, principles and procedures. Office for National Statistics. Available here.
8 – Users and uses of consumer price inflation statistics. Office for National Statistics. Available here.
9 – Citizens Not Fooled by Fake Statistics. UCLA Anderson Review. Available here.
10 – Consumer Price Inflation QMI, 7: Validation and Quality Assurance. Office for National Statistics. Available here.
11 – Measuring the Real Cost of Living (2013). Tullett Prebon. Available here.
12 – If people knew the actual inflation rate, it would implode the entire system. Available here.
13 – The economic outlook, 1.2: The MPC’s projections; CPI inflation. Bank of England. Available here.
14 – Inflation post Covid-19: to be or not to be? Available here.

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