Finances, Financial planning, pensions

What exactly is inflation and how to beat it

Have you ever wondered how accurately inflation is measured but never really cared to look it up? Should financial plans for early retirement (FIRE) assume a 2.5% rate of inflation, as I’d done ?

Here, I explore what the UK inflation rate is, what it means to FI plans, and ways in which we can try to ‘beat’ inflation in our spending and saving. This is UK inflation 101 for the FIer – the PathtoLife2 version.*

Image result for inflation
Inflation – not usually this attractive.

So, my vague understanding was that the inflation rate is an index based on some large basket of typically bought items which may change once in a while and which may not include mortgage payments (no longer the case). But I often wondered how inflation continued to surge upward of a few percent a year. Was it real? Do people really lose money when saving it in a high interest account due to inflation? This is what motivated me to read up. After all, this is important both in terms of how much I’d estimate I’d need to live on post-FI and in terms of the investment strategy I might take.

Inflation: A slightly mystical thing?

The odd thing about inflation is that how it’s measured has changed and continues to do so surprisingly often, both in terms of the precise items included to define inflation and the indices themselves. Two indices you’ve probably heard of are CPI and RPI** – CPI introduced in 2003 and RPI being around since 1947. Then in 2013, grown-up four-letter versions of these indices came into being (CPIH and RPIJ). The former includes housing costs (from the mortgage to house renovation to bills), while the latter uses ‘weighted’ calculations not used in the RPI (but is used in the CPI).

Interestingly, the CPI tweaks its basket every year though most items remain the same. This is based on data collected by hundreds of fieldworkers monitoring price changes in 140 locations across the UK and on the internet. To give you a few examples, 2017 added gin and non-dairy milk (almond, soy and rice), 2018 added soft play sessions, leggings (both ladies and girls!) and 39 inch+ TVs, and 2019 added voice activated smart speakers, dog treats and electric toothbrushes. Strangely fascinating – at least if you’re anything like me.

And the inflation basket rejects? Amongst other things, menthol cigarettes and kiddie swings in 2017, pork pies and ‘bottle of lager in a nightclub’ in 2018, and envelopes, crockery sets and hifis in 2019. Hm, I can kind of see the point here, or at least, I haven’t bought any of those things any time in recent living memory…

So, what I hadn’t been so conscious of until discovering the regularity of such changes is that the CPI is also used to monitor our consumer habits. In that regard, I find it pretty interesting. On the other hand, is it just me or is there something a bit strange about using the most typically bought products – which have prices already driven up due to demand – as the basis for calculating how much lifestyle costs have risen? So, the inflation rate (a thing that’s worried government since the 1960’s) is by definition driven by what people spend and thus typical lifestyle expectation.

Does inflation reflect lifestyle expectation?

So, this is not to say that the cost of things don’t rise, but rather that the inflation rate is influenced by societal expectation of what one should spend and on what, so is always bound to rise (as long as there’s money or credit). It follows then that if you are not the typical UK shopper (as are many FIers), then the inflation rate should be less applicable.

Although, by definition, huge swathes of the population are the typical shopping household, few will shop identically to the CPI basket and so the reported inflation rate should be higher than the price increases many individuals experience in real life – if the laws of supply and demand are to be believed.

Also, it makes sense that people respond to inflation – if raspberries (new in the 2019 CPI basket) were looking expensive (anchored against an expected price I have in my head, assuming I have one!), I may buy grapes more. This is the spending behaviour of those who are looking to maximise their pennies, like me.

Of course, indirectly, if spending in one area increases for enough people, such as with fuel, food and/or transport, then I’d assume that inflation will eventually have a knock-on effect on other areas, such as services, or from one food type to another. I’m not saying that’s always the case, just that I imagine there are both direct and indirect impacts from spending to inflation. In that sense, the FIer isn’t immune even with unconventional spending habits, unless you really are off the grid!

Which inflation rate do we officially follow?

As you may have guessed by now, the CPI (or CPIH) is usually used as the measure of inflation. Since 2011. The RPI is consistently 0.9% higher than the CPI, mainly due to the statistical formulas used rather than content differences, an is no longer has ‘national statistic’ status. Yet, the RPI is still used for government index-linked bonds, social housing rent increases, and employer wage negotiations.

UK state pensions will increase in line with CPI, increase in average earnings or 2.5% – whichever is higher. That’s the triple lock you may have heard about. If you believe the Guardian, the triple lock will move to the less generous double lock in future. In my opinion, it seems inevitable regardless of who is in government.

And now I believe that if the state pension increases in line with CPI, it’s probably quite generous, given my points above. But of course, this can depend very much on which areas we see inflation in. If fuel and food bills go up in price faster than other goods and services, pensioners will be disproportionately hit.

My memory was that my closed pension account increases with inflation. On inspecting the paperwork, it does mention increases following inflation. But then the statement says that the benefits are revalue ‘in line with standard pension increases’ – which was 1% in 2017-18 and 3% in 2016-17. Maybe I’ve missed something here, but there’s definitely a lack of detail!

So what is the current inflation rate?

The CPIH is currently running at 2% for the last year, and 1.9% the year previous. Our US cousins also experience a similar inflation rate (1.9%). As I’d been using 2.5% when making long-term future projections in inflation calculators, I will in future reduce this to 2%, bearing in mind all the points above and also allowing some savings cushion. This is, of course, not to be taken as recommendation. No one really knows what future inflation rates will look like, I don’t think.

Which areas of spending account for most inflation?

The CPI changes a surprising amount in terms of weighting, such that many websites that published ONS statistics were dated, so I went to the latest ONS stats (March 2019). While food and drink accounted for a lot of inflation a couple of years ago (that may be when we defected 90% of our food shop to Aldi), now it’s housing/household, transport, recreation/culture and restaurants/hotels. These are the current drivers of inflation. See the table below.

Obviously, there is a lot of variation within each category. I’d argue that if you’re in the frugal lifestyle, you’re less subject to official inflation, because what you’re purchasing is not as in line with the typical shop. Not that buying items outside of the CPI basket is necessarily the solution (given my point above about indirect effects), but by default they will be the less popular things that don’t ‘demand’ price increases.

  CPI basket Overall %  weight* Variation in price
change 2013-17*
% of total items
Food & beverages 8.0 Medium 24
Alcohol & tobacco 3.2 Medium 4
Clothing & footwear 5.7 Medium 11
Housing / household services 29.8 Low 5
Furniture/ household 5.2 Medium 10
Health 2.2 Low 3
Transport 12.4 Medium 6
Communication 2.0 Medium 1
Recreation & culture 12.5 Medium 17
Education 1.8 Low 1
Restaurants & hotels 9.8 Low 7
Other goods & services 7.4 Medium 11
Office for National Statistics

*Jan 2019 **Not that meaningful given the amount of change between 2017 and now.

Most people are very much subject to the whims of price changes in food, fuel costs and housing-related costs – since these are regular costs that mostly can’t be avoided. But what are housing costs? At the moment, the biggest contributor to the inflation rate in that category is fuel (gas, elec, other), even larger than mortgage costs and rent (almost negligible). It makes sense if it’s fuel that’s gone up in price this year. Yet this isn’t what you imagine when you think about how housing might contribute to inflation rates.

In the last 12 months, the biggest increase came from games and hobbies, especially computer games and consoles, which we’re immune from (for now!). What I find crazy is that this increase was 8.4%, which is up from 4.1% in 2018. The ‘moral’ of that story is definitely to develop low-cost non-corporate interests or unusual ones no one else wants! If I didn’t know any better, I’d be thinking that these greedy corporates are making highly addictive gaming.

But are goods really always increasing in price?

Image result for groceries
Sorry, but you forgot to include my gas bill, soft play session and tuition fees here…

I’m not exactly sure how but I vaguely thought inflation ‘mainly’ applied to a basket of goods in the concrete sense, so not services, but this was a wrong assumption. Even university tuition fees are in there! (This to me is a bit weird given that fees aren’t usually paid upfront and are capped by government and therefore less directly linked to supply and demand.)

For many years, I’ve wondered whether the real cost of many things have actually decreased and why isn’t that taken into account in inflation. My experience tells me that the cost of a take-away in the city or a pair of pants (trousers) have definitely not increased 2% year-on-year since I was a teenager! I paid £30 for a pair of pants as an 18-year-old and might pay even less than that today. I found out that deflation IS taken into account, but is offset by inflation that’s more common.

The ONS states: “In the UK goods sector, inflation has fallen steadily over the last 15 years, with many goods actually deflating in price. In contrast, service sector inflation has continued at around 4% to 6% per year”.

That’s a big difference! And that’s a trend over the last decade and a half, as people increasingly use services. However, over the last year, transport and housing/household services were deflationary. And this year alone (as in, Since Jan), clothing and footwear were deflationary. I guess that may be reflecting how much the high street is in trouble! Am I allowed to feel sorry for Debenhams et al.?

So, if you don’t use many services, then it seems that the inflation rate is less relevant to you. The more similar your spending is to the average, the more it is relevant. Prepared mash from the supermarket anyone? (Yes, that made it into the CPI basket this year…)

Is there hidden inflation?

I can’t recall the book I read on this off hand, but are the size of things getting smaller? Chocolate bars, packets of Quorn, packets of food that seem to feed 1 but give a serving suggestion of 3 meals? Crisps used to be in bigger packs, that’s for sure! Maybe some items have less in a pack AND increased in price? This phenomenon isn’t taken into account in the inflation basket, I don’t think. Ouch. Maybe time to switch brand?

How to spend to ‘beat’ inflation?

Er, don’t! Generally speaking, the more frugal and unconventional your lifestyle, the less the inflation rate applies to your own personal experience of price hikes over time. The more resistant you are to lifestyle inflation, the less price inflation rates will apply – since the CPI’s very nature is to reflect typical spending pattern rather than track a fixed basket of costs (e.g. milk, bread, meat, furniture).

If you’re frugal, congratulations, you already have a built-in ‘inflation evader’. You won’t necessarily be brand loyal. You’ll make conscious, not habitual, purchasing decisions. Although I couldn’t find anything online about whether the CPI includes discounted prices, it seems very likely that if you’re getting sale items, discounted items (e.g. negotiating, near use-by date, bulk buying), shopping around for your big ticket stuff, then you’ll be “ahead of” inflation. Independent shops may also be slower to pass on rising costs or may hike them up gradually. Buying second hand is another solution.

I can think of 2 other points for avoiding inflated costs. Firstly, might the FIer use fewer services when they’ve FIREd? I am thinking of the various services you may take to help make life more bearable in your job? The helpful stuff, the distracting stuff. Like eating out after a tough day at work, like having a cleaner, like more weekend getaways to feel like we’re living a little. Hotel and restaurant prices continue to escalate…

Look around your home, assuming you’ll still live there post-FIRE, are your belongings item proofed? The more long lasting your things, the less inflation applies, right? Buying long lasting stuff avoids years of inflation! Good quality is inflation’s enemy. I’m hoping our furniture has at least 10-20 years if life in it. I may factor in the one off cost of 1 set of new furniture, maybe when we’ve downsized.

But overall, the rising cost of living means that inflation will eventually reach all unless you truly live like a hermit. So I definitely take inflation into account for living on especiallt in the 10 years before the inflation-cushioned pensions kick in.

Inflation-busting investments and savings

What exactly is inflation in the market? Surely, price rises must be reflected in market growth to some degree. So, equities and index funds would also inherently have built in some price rises. As we saw earlier, inflation rates also reflect typical lifestyle and living standards, which must stimulate demand in the market. But returns are in no way guaranteed.

Are index-linked bonds the answer? I’m no expert on this, but although they follow the RPI to provide some ‘inflation resistance’, the real return can still be zero. If you believe this article, then there are a narrow set of circumstances when investment in index-linked bonds is considered ideal. It sounds like you might want a sizeable portfolio before considering adding these bad boys.

And are our savings simply eroding in our bank accounts? In real terms, I’ll tend to think that if you can get 2% upwards (e.g. fixed rate accounts), your moolah is not being completely chipped away by inflation (plus it’s pretty much guaranteed you’ll get this return). That’s taking into account the various points I made above, all tending toward the FIer’s efficient use of money. In the end, it’s what you spend the money on that counts. Inflation erodes spending power, not savings.

Plus when you put your money away, whether in investments or savings, you’re buying more than simply an inflation-linked future cost of living, but a lifestyle of freedom. How do you quantify that?

Thanks for reading. This is my first research-led article, so let me know if you enjoyed it. Please do share if you have a different view to offer or if there are any corrections.


*I have no financial training, so please ensure you do your own research before you make any financial decisions based on any information given here. Thanks.

**Consumer Price Index (CPI); Retail Price Index (RPI)

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