Inflation, deflation and the CPI

Inflation, deflation and the CPI

Inflation is a sustained rise in the general price level over time. Deflation is a sustained fall in the general price level. Disinflation is when prices still rise, but more slowly than before.

Notice the word general: one price rising (say, butter) is not inflation. It is the overall level that counts.

In Ireland the Central Statistics Office (CSO) measures this with the Consumer Price Index (CPI). The CPI tracks the cost of a typical "basket" of goods and services bought by households: food, rent, fuel, transport, clothing, restaurants and so on. Each item has a weight showing how much of a typical household's spending goes on it. Rent has a bigger weight than cinema tickets, so a rent rise moves the CPI more. The CSO publishes the CPI monthly and updates the basket and weights regularly, for example when new items replace old ones. The ECB's 2% target is measured with the HICP, the harmonised version of the index used across the eurozone. It is built in a similar way to the Irish CPI but differs in coverage: for example, it excludes mortgage interest costs, so the two rates can differ a little.

A price index sets a base year equal to 100. Later values are measured against it:

Why an index? Raw prices of different goods (a €1 tin of beans, a €900 rent) can't be added meaningfully. An index turns every change into a comparable percentage and lets us follow the whole basket over many years.

Weighted averages

When items have weights, the overall price change is a weighted average of each item's change.

Causes of inflation

There are two main types.

Demand-pull inflation: total spending (aggregate demand) grows faster than the economy can produce, so firms raise prices. Typical causes:

• a rise in consumer spending, for example after tax cuts or rising incomes;

• a boom in investment or higher government expenditure;

• strong export demand;

• an increase in the money supply or cheap credit (low interest rates).

Cost-push inflation: firms' costs rise, and they pass them on in higher prices. Typical causes:

• higher wages not matched by higher productivity;

• higher import prices, such as oil, gas or raw materials;

• higher indirect taxes (VAT, excise duty) or a weaker euro, which makes imports dearer;

• higher energy costs or supply disruptions.

Who gains and who loses from inflation?

Inflation matters because it changes real values. Real income is what your income can actually buy:

If nominal wages rise 3.5% while inflation is 5.5%, real wages fall by about $3.5 - 5.5 = -2.0\%$.

When inflation is unexpected:

• Losers: savers (the real value of savings falls, especially if the interest rate is below inflation); lenders at fixed rates; workers on fixed-wage contracts; people on fixed incomes, such as some pensioners.

• Winners: borrowers (they repay in money worth less, so the real debt falls); the Government as a debtor (the national debt shrinks in real terms and tax revenue rises with prices); workers who can bargain wages up quickly.

Competitiveness: if Irish inflation is higher than in our trading partners, Irish goods become dearer relative to foreign goods (the euro exchange rate with eurozone partners can't adjust). Exports fall, imports rise, and jobs in exporting firms are at risk. Low relative inflation does the opposite and helps competitiveness.

Deflation

Falling prices sound great for shoppers, but persistent deflation is dangerous:

• Consumers delay spending, expecting lower prices tomorrow. Demand falls, which pushes prices down further: a deflationary spiral.

• Debt burdens rise in real terms: you still owe €200,000 but your wages (and house value) are worth less. Defaults and bank problems become more likely.

• Investment falls: firms see falling revenues and lower profits, and postpone projects.

• Wages and jobs: firms facing falling revenue cut wages (which workers resist) or lay off staff, so unemployment rises.

Moderate inflation (about 2%, the ECB's target) is seen as healthier: it keeps spending flowing, makes it easier for relative wages and prices to adjust, and erodes debts gently.

Limitations of the CPI

The CPI uses a fixed basket, which creates problems when comparing it with the real cost of living:

• Substitution bias: when beef becomes dear, people buy more chicken, but the basket still assumes the old mix, so the CPI overstates the rise in the cost of living.

• Quality changes: a phone costs the same as last year but is far better. The "real" price has fallen, yet the CPI may not capture it.

• New products: goods that were not in the basket (new streaming services) take time to be included.

• Housing costs: rents, mortgage interest and house prices behave differently; how they are treated changes the measured inflation. Owner-occupiers feel mortgage costs, not rents.

• Household types: pensioners, students, rural and urban families all spend differently, so an average basket suits none exactly.

How the CSO responds: it updates the basket and the weights regularly, using the Household Budget Survey; it replaces items that have disappeared; it adjusts for quality changes; and it publishes the HICP (Harmonised Index of Consumer Prices), which allows comparison with other eurozone countries. Some indices, such as CPI excluding mortgage interest, are also published.

Controlling inflation: interest rates

Inflation in the eurozone is the responsibility of the European Central Bank (ECB), which aims for inflation of about 2% in the medium term. Its main tool is the interest rate.

How higher interest rates reduce inflation:

1. Borrowing becomes dearer, so consumers and firms borrow and spend less (lower consumption and investment).

2. Saving becomes more attractive, so households spend less.

3. Mortgage holders on variable rates have less disposable income.

4. A stronger euro (as capital flows in) makes imports cheaper and exports dearer.

5. Aggregate demand falls, reducing demand-pull pressure on prices.

Consequences: unemployment may rise as firms cut investment and output; mortgage holders face higher repayments; investment and house-building fall. It is a trade-off between lower inflation and slower growth.

Limits: interest rates are best against demand-pull inflation. If inflation is cost-push (imported energy prices), higher rates don't reduce the cost of oil or gas, and they reduce output further, risking higher unemployment (stagflation). Also, Ireland is in the eurozone: the ECB sets one rate for all members based on the whole area's conditions, so it may not suit Irish circumstances, for example a booming property market.

Back to the start: the cinema ticket rose from €9 to €12, about 33%. Unless your pocket money rose by more than the general inflation rate over that time, your real purchasing power has fallen. The CPI is the tool that lets us say so with numbers.

Summary