Inflation: Taxation without legislation

August 20, 2018 - Paul Fazackerley

Last week the Office for National Statistics (ONS) announced that UK inflation rose to 2.5% in July, having been static at 2.4% the previous three months. This increase represented the first jump in the Consumer Prices Index (CPI) measure since November 2017. Meanwhile the Retail Prices Index (RPI) measure of inflation for July fell to 3.2%.

Whilst inflation (CPI) is still above the government’s long-term target of 2%, the good news is that it stayed below the Bank of England forecast of 2.6% for July. What’s more, this week official data showed average earnings, excluding bonuses, rose by an annual rate of 2.7% for the three months to June, which is a further positive.

What’s the difference between the CPI and RPI?

People often talk about the Consumer Price Index and the Retail Price Index in the same breath, however there is a slight difference. In simple terms the CPI is used to measure how the price of a basket of goods and services varies over a period of time. The RPI looks at the same basket of goods and services, but also includes the costs of housing (mortgage interest costs and council tax for example).

Unfortunately, it isn’t that simple. The complicated bit – and the more relevant difference between the two – comes in the calculations. The RPI is calculated using an arithmetic mean. This means adding up the prices of everything in the ‘basket’ and then dividing by the number of items. The CPI however uses a geometric mean. This is when you multiply the prices of all the items together and then take the nth root of them, where ‘n’ is the number of items in the basket.

According to the ONS “an advantageous property of the geometric mean is that it can better reflect changes in consumer spending patterns relative to changes in the price of goods and services.” Whilst that may be true, the real advantage to the government of using a geometric mean is that it is always below (or equal) to the arithmetic mean.

The result is that the CPI usually sits about 1% lower than the RPI. Hence why the government likes to link the payments it makes (such as pensions) to CPI and payments it receives (taxes, etc) to RPI.

What’s in the basket of goods and services?

At a high level the basket is divided into 12 main categories:

  1. – Food and non-alcoholic beverages
  2. – Alcohol and tobacco
  3. – Clothing and footwear
  4. – Housing costs (such as gas and electricity)
  5. – Furniture and household goods
  6. – Health
  7. – Transport
  8. – Communication
  9. – Recreation and culture
  10. – Education
  11. – Restaurants and hotels
  12. – Miscellaneous goods and services
  13. Within each category is a list of items which are selected based on current typical shopping habits. As shopping habits change, so too does the list of items used. For example in this year’s review of the list of items, amongst other things, out went pork pies, peaches and digital camcorders, and in came quiche, raspberries and body moisturising lotion.

What does this all mean for me?

To put it simply, the higher the rate of inflation, the more expensive things are.

If 12 months ago your annual outgoings totalled £25,000 and the rate of inflation is 2.5%, that means your outgoings today would be £25,625. That’s an increase of £625 for effectively the same basket of items. To maintain the same standard of living as you had 12 months ago your income therefore needs to have also increased by at least £625.

But there’s more to it than that, and this is the area people often forget about. We often think of money held in the bank as being safe or risk free. Whilst that may be true in terms of a market crash, it’s not necessarily safe against the impact of inflation.

The chart below shows the purchasing power of £100 over time when inflation is 2.00% (the government’s long-term target) and 2.50% (the current level). In both scenarios this illustration assumes you’re not earning any interest on your money in the bank.

If the government’s long-term target is achieved, then over a 20 year period the purchasing power of your savings will have decreased by approximately a third.

What should I do?

When managing your finances against the impact of inflation, there’s not always a straightforward answer. In simple terms you want your investments to outperform the rate of inflation. However there may be times where you want to hold money in the bank, such as for an emergency fund, for short term expenditure or if cash remains an appropriate asset based on your risk preference and objectives.

When looking at potential returns you also need to factor in other costs that may apply such as financial adviser fees, wrapper/product costs and investment related charges. Just like inflation, these will also erode the purchasing power of your money.

At the same time it’s important to remember that risk and reward are typically linked, so to achieve greater returns you usually need to take greater levels of risk.

All these things factored in, the best course of action really is to speak to a financial adviser. If you have any questions, we’d be more than happy to help.

Past performance is not a reliable indicator of future results.

The value of investments can go down as well as up and you may get back less than your initial investment.