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Inflation is much in the news. In fact, in the past two or three weeks it’s come to take centre stage in the discussions about where interest rates are headed and what we should do about it. The Bank of England is charged with keeping the inflation rate down below 2%. Currently it’s much higher, and seems to be headed higher still.
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But the published, official inflation rate is a strange beast and it’s not at all clear exactly what it measures. It’s based on the idea that there is a shopping basket of goods that represents what Mr and Mrs Average Briton might spend their money on.
Every year, the basket is updated to reflect our changing tastes. The last time this exercise was carried out, in came iPods, muffins and Starbucks cappuccinos. It currently gages prices on over 600 items including such arcana as a full leg wax, acoustic guitars and replica football kits. As such, it is trying to replicate what we have been spending our money on, rather than concentrating on the cost of basics, such as petrol, mortgage interest payments and the weekly supermarket shop.
The problem with this approach is that it places huge weight on non-essentials. It’s not possible to be precise about just how much because what is essential for one family is frivolous for another, but something like half the basket is made up of items that could either be lived without very easily or substituted for something much cheaper. For instance, in the 2006 changes, imported sparkling wine was replaced by champagne, because “market research indicated that expenditure on champagne dominates the entire sparkling wine market.” So it might, but is that really a good reason for champagne to enter our cost of living calculations? Currently very few if any of these discretionary items is going to be going up in price, so consequently where the inflation action currently is — oil, fuel and food — is masked by all this upmarket dross that’s in the index.
But there is another issue here that remains little discussed. Consumers are not dumb automatons. If a price rises significantly, we react by buying less of it or switching to something cheaper. Or by cutting out non-essential items, like champagne. That is what downturns are all about. Which begs the question, what exactly does the inflation rate measure? Currently it tells us what we were spending last year at the height of the economic boom, not what we are spending now and over the coming months and years. It’s a lagging indicator if ever there was. And of course there is one big category of spending which is absent from both the RPI and the CPI and that’s the cost of housing, which is currently falling as fast as oil prices are rising. Unlike the CPI, the RPI includes mortgage rates, but neither index includes house price data.
The question is, why on earth should we be using these arcane measurement tools to determine our interest rates? I am aware of the economic arguments that indicate we should be keeping interest rates a little higher than inflation, otherwise there is no incentive to save and invest, but can we actually define what inflation is? I don’t think we can, not in monetary terms.
So perhaps it’s time to link interest rates to something more meaningful. How about carbon dioxide emissions? Growth in CO2 has, to date, been a pretty accurate indicator of industrial activity and we now understand that it’s something that can’t go on at the rate it has done, let alone be allowed to grow. What better way to dampen CO2 output than using monetary policy? How would it work?
Rather than trying to measure a theoretical basket of prices, the economists would be set to measure our fossil fuel usage, aggregating our use of gas, coal and oil, and adding and subtracting something for the embodied energy in our imports and exports. There would be targets for reducing this figure, year on year, and if these targets were met, interest rates would be kept low. If the targets were missed, interest rates would be raised and this would in time dampen general economic activity, which should in turn act to lower CO2 emissions. It would become a virtuous circle. Monetary policy would act to stimulate smart low-carbon growth and to penalise smokestack industries and gas-guzzling transportation and heating systems.
Maybe after 30-odd years, we might just have got CO2 levels down by 80% or whatever the target will be by that time. Job done. Then perhaps, we could set the economists a new target, measuring happiness instead, lowering interest rates if we become too miserable and raising them if we are in danger of getting carried away by euphoria. That might be an appropriate time to re-introduce champagne into the index.
To link the economy to the environment in such a way is a great thought. All that is needed is a politician with good understanding in both economics and the environment to take the idea under their wing.
Posted by: Alistair Gould | 20 June 2008 at 02:24 PM