Fahrenheit 101 – why inflation indices are so controversial.

We measure inflation using “indices”. They are at best, very rough guides to the change in “average” prices in our economy.  But they’re fraught with problems, like “whose average?” Or indeed who is Mr and Mrs Average? So the debate as to which method is righ is very important. We’re seeing such a debate in the UK at the moment, and it’s rightly politically charged. But does it matter and why?

In this note I show that it’s all potato or potahto, or more appropriately, Celsius versus Fahrenheit. And why some actually should care.

Whats’s the temperature?

We create price indices by measuring expenditures on baskets of goods and services, and weight them by the relative proportions the average person spends. Mr Average may spend 10% on energy, while only spending 1% on recreation (although after England’s World Cup success, that probably rose in July to 5%! But our indices aren’t interested in the blips). It’s not perfect but it’s the best we can do. We measure the rate of change in the index as the inflation rate.

However, we can have different Mr & Mrs Average – each of us buy different stuff, and therefore our individual inflation rates can be very different. In the UK there are a plethora of indices, each with different weights for things like housing and energy. Some even employ different mathematical calculations. If you’re intrigued, google away, but this is not my point here.

Because some stuff has a sustainably higher or lower inflation rate, by incorporating more of them in an index, one will see that measure sustainably higher or lower than others over time. In the UK that has been the experience with RPI, which has been about 0.5% higher than other measures like CPI. Similarly, in the US, CPI has been about 0.5% above the Fed’s preferred measures of PCE.

So does that mean, if we moved from higher measures like RPI, to lower measures like CPI, it’ll be deflationary?

Actually it’s neither inflationary or deflationary.

Let’s think about temperature – if we all use Fahrenheit, and you meet some one who uses Celsius, when they tell you it’s 15 degrees  while you think it’s 59, make any difference to you? Feel cooler?

Of course not. But then again?

In reality the inflation indices only matter in two ways;

1 – the “money illusion” that 59 is “hotter” than 15. By telling people it’s hot, that can change their perception. And perception is reality.

In terms of inflation, being told that its visibly racing away, even when the prices you face seem quite calm, can indeed change your actual economic behavior. Similarly, by convincing the populous that inflation is under control, and close to target, central banks can indeed influence economic behaviour.

2 – the most important way is through the indexing of payments. Where one gets paid cash flows based upon an index, of course you’d prefer Fahrenheit over Celsius! Think government social security payments, your tax deductions, government bonds related to inflation, and of course pensions.

Given 37% of government income goes to cover these social outlays, it’s clearly desirable. But the recipients will lose out.

This is why in the UK, the sanctity of RPI matters, and don’t be surprised if attempts to “moderate” the RPI, or even replace it, trigger riots, either on the streets, or in financial markets. 

Making “Fahrenheit (aka RPI) much smaller” would of course make it easier to move to Celsius (CPI) eventually. This is the emphasis of the debate in parliament and of course it’s making many hotter under the collar.

But by simply moving to Celsius, it won’t actually change the true temperature. 

So is the move to the lower CPI indices deflationary ?

Well, only if it changes the behavior of those whose incomes depend upon RPI-related cash flows, such that they lower consumption, and hunker down.

Otherwise, it’ll have no impact on the actual temperature we truly feel.

Potato, or Potahto….