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FTBagain

Does Credit Lower The Inflation Rate?

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Much has been commented about inflation and the Shopping Basket used to calculate the official CPI figures. That has got me thinking, and the following occured to me the other day. I thought I would share these ideas with you sure in the knowledge that you would correct any errors in my logic. Enjoy.

Does Credit Lower the Inflation Rate?
I contend that it does.
It is a stage thought, but actually when you follow the logic it is quite simple. It is dependent on the ‘shopping basket’ used by the Statisticians responsible for measuring the Consumer Price Index (CPI) and how the CPI is calculated from that basket. The shopping basket is supposed to represent the ‘typical’ weekly shop for the nation being monitored, and while there is increasing controversy over accuracy of the UK basket that is an issue that has been discussed many times elsewhere, so I am going to assume, for the moment, that the basket is a fair reflection of the spending patterns in the UK.
In order to follow the logic we need to understand how the CPI is calculated from the basket. First, of all we must realise that not all items of the basket are considered has having equal weighting on our purses. Each item is factored by the proportion of our income we spend on that item. It is this weighting that is the key point to my assertion the increased credit equals suppressed inflation in the current world economic climate, so I will spend a moment or two explaining how each item in the basket is weighted.
Let us create a simple basket of just four items. If each item costs the same then they will each contribute 25% to our cost of living, so any increase in cost of any given item will be weighted by 25%. In other words, if all the items doubled, the cost of living would double, but if only one item doubled the cost of living would rise by 25%. In other words the doubling in price of one item in our basket gives an inflation rate of 25%.
Now if we spend different amounts on each item, for example, half our income on Item 1, then Item 1 would contribute to 50% of the cost of living, the other 3 items would each contribute about 16% (50% / 3), assuming they cost the same. If the cost of Item 1 doubled then our inflation rate would be 50%, if the cost of any other item doubled the inflation rate would be 16%. Quite a difference.
So the inflation rate is dependent on not just the cost of an item, but also on the proportion of our income spent on that item. That means that any given item can ‘weight’ the inflation figure. If all the items in the basket went up at the same rate then there would not be a problem, but as we all know they do not. In the current global economic situation, energy prices are rising, but labour prices have, up until recently at least, fallen. This means manufactured goods whose price is made up of labour and energy costs have been seen their retail prices fall, because the falling labour cost have more than off set the rising cost of energy. However, as we are starting to become all too painfully aware, the direct cost of energy, to light and heat our homes etc, is rising fast.
As the proportion of our income spent on energy increases, then the weight applied to energy will increase (or should do, only time will tell). There is also the fact that if income remains responsibly stable then spending on some items will be curtailed, further changing the weighting on the items in our basket.
Now this is where credit and MEW can have an impact on inflation. If our incomes our supplemented by MEW ing then we will be able to continue spending money on discretionary items. As these items tend to be manufactured and their prices have been falling then our ability to buy them and ensure they are kept in the Inflation Basket, means that we will put a downward weight on inflation. However, if we are unable to borrow then we will not be able to buy the discretionary items, which should lead them to be removed from the Inflation Basket, removing the downward pressure on inflation.
So what does this mean in economic terms. Well, if the banks start to introduce tighter credit rules as a result of the increasing risk of default on loans, the inflation rate, will, in the short term at least, start to accelerate as those non-discretionary items in the basket that are increasing in cost start to dominate the inflation figures. This could cause the Central Banks to increase the base rates further to combat rising inflation. Rising rates would, in turn, increase the risks associated to lending. Given the traditional risk aversion of banks, this would lead to further credit tightening, creating a vicious circle of rising inflation and increasing credit control.
Clearly, the item mix in the basket is critical, but judging the accuracy or otherwise of that mix is difficult. Why, because the mix is an average representation of the spending patterns of everyone in the country and is probably, therefore, representative of no one person. We each have our own basket, so we each have our own personal inflation rate. If we do not borrow and spend on discretionary items, we will be clear of debt, but our personal inflation rate will be rising faster than the average CPI figure. This will be true for any group who can not afford to buy those discretionary items including the OAP’s, hence the assertion highlight in some papers last week that the inflation figures for OAP’s is nearer to 5 or 6%. Take those discretionary items out of the basket, and real inflation will probably be near to 5 or 6% for everyone. I wonder what the BoE would say about that?
FTBagain

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can i summarise your post as being MEWing (rather than salary increase) has been allowing people to buy more stuff like furniture which has been keeping the official CPI rate down?

seems a good point to me

Thanks.

In a nut shell yes, but I was trying to put some 'weight' behind the arguement and also check to make sure my understanding of the CPI calculations is reasonably accurate.

Edited by FTBagain

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I think you did so very well - it is an interesting argument that I hadn't considered before - it is especially pertinent when we are told that one of the factors that recently reduced the CPI figure was the falling price of furniture

Furniture?

How often does anyone buy furniture? It's daft.

I think the BOE (as clearly the ONS would not) should consider core Inflation as being the CPI with the discretionary items stripped out. Not energy. As someone has pointed out on another thread today, energy is critical and if you are an OAP, energy is critical to your very survival. Stripping it out of the 'core' inflation figures is not just silly, it is potentially murderously miss-leading. OK a bit extreme, but it is very irritating being told inflation is 2.4% when clearly for many (possibly most) it is much higher. :angry:

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  • 302 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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