January 25, 2007

Inflation in the U.K.

In many ways, the United Kingdom is a miniature version of the U.S. They too are one of the few Anglo Saxon countries having an outsized trade deficit and budget deficit, they are graced by an enormous housing bubble, they are one of the world's great financial centers, and their population is accustomed to a position near the top of the heap of world powers.

Another very important similarity between the two countries is a festering inflation problem that no longer seems to be quelled by cheap imported goods from Asia and moderate energy prices.

In many ways, rising prices are much more acute in the U.K. than in America.

With a rapidly growing world financial center in London, the country has been a popular destination for those with petro-dollars to spare. And what appeared to be a bursting housing bubble a year ago has been reinvigorated - with home prices again rising at double-digit rates (closer to triple-digit rates in tonier areas), it now looks more dangerous than ever.

In recent years, the government agencies charged with maintaining confidence in the currency have been successful in continuing to report low single digit price increases. Aided by excluding or reweighting one thing or another and by undergoing ever more severe contortions in the actual calculations, reported inflation has remained tame.

In 2006, Everything Changed

Earlier this month, prompted by continuing concern from many corners that the government's inflation statistics are not consistent with real-world experiences, the Office on National Statistics (ONS) made available a personal inflation calculator.

It was a big hit.

Some families found that their personal inflation rate was closer to 10 percent while at the same time the new tool was criticized for not including sharply rising education costs.

Just before it became official that inflation had jumped to a ten-year high, the Bank of England surprised nearly everyone by hiking short-term interest rates by a quarter point to 5.25 percent.

Bank of England Governor Mervyn King was on top of things. Foreign currency traders liked what they saw and the currency strengthened.

The Brits have two official figures for inflation. Their Consumer Price Index rose from 2.7 percent to 3.0 percent in December, driven higher by rising energy prices. The separate Retail Prices Index, which includes mortgage payments, rose from 3.9 percent to 4.4 in December.

These are terrifying numbers for central bankers.

The CPI reading came a whisker short of the 3.1 level that would have required Mr. King to pen a letter to Chancellor of the Exchequer Gordon Brown explaining why the Monetary Policy Committee missed the two per cent inflation target by more than a full percentage point.

The impromptu interest rate hike caused the banks to withdraw fixed rate mortgages from the marketplace, bankers apparently fearing that rates would go higher still. Prospective homeowners and those looking to refinance were not pleased.

The Telegraph is on the Case

The staff at The Telegraph newspaper then did some more tinkering with the government's new inflation calculator and found that "personal" inflation rates were much higher than the government's official number - at least in the cases they featured in their report.

Allison Lauder, a 32 year old solicitor had a calculated personal inflation rate of 7.4 per cent versus the ONS figure of 4.4 percent. John Yates, age 77 and retired, registered 7.5 per cent versus the ONS's estimate of 3.9 per cent. And Niki Chesworth, a 44 year old freelance journalist and her partner, Guy, a 45 year old engineer, posted a personal inflation rate of 8.7 per cent, double the figure from the ONS.

Naturally, Mervyn King scoffed at the notion that the government understates inflation.

Gordon Brown stepped in to take some responsibility for the "inflation mess", and then the graphics department at The Telegraph just got a bit silly in a piece titled, "Be a winner at the great inflation race".

The report urged the fixed-income set to start taking on a bit more risk for a better return - for those willing "to take the plunge, stock market investments provide a better chance of outpacing inflation." No promise of victory was made.

The image above has the same feel as that Inflation Monster cartoon put out by the EU about a year ago - something about capturing the little bugger and sealing him in a jar to make the world a better place.

This sort of thing really isn't very funny, especially if you're a pensioner (retiree). Almost five million seniors in the U.K. live on less than £10,000 a year (approximately $20,000) with one-fourth of pensioners counting the £4,381 ($9,762) full basic state pension as their only source of income.

Each year, pensioners fall a little further behind.

Another piece urged savers to Wave goodbye to inflation by seeking higher yielding fixed income investments. This task seems to be made even more difficult as other measures of inflation come to light. According to investment bank Barclays Capital, a simple index of "essential inflation" jumped to 8 percent in 2006 - this measure includes such essentials as food, property tax, utilities, and gasoline.

For many the numbers just don't add up. It's a losing battle - a race that can't be won.

It seems that the only way to get the better of inflation is to take on a level of risk that most people, understandably, are reluctant to do. And it's probably going to get much worse - in both the U.K. and in the U.S.

It didn't have to be this way.