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OPINION

Our measure of 'core inflation' is very flawed

Our measure of 'core inflation' is very flawed
February 23, 2023
Our measure of 'core inflation' is very flawed

Core – should that be ‘core’ as in the most important part of anything (presumably derived from the Latin cor or heart), or should it be ‘cor’ as in ‘cor blimey’ (a derivative of Gorblimey)? The difference is important, or it is if the subject under discussion is inflation and the damage it may be inflicting on the UK.

Inflation is yesterday’s problem, goes one topical line of thought. As if to beef up that notion, just lately we hear lots about core inflation, the inflation rate that gets to the heart of the matter; the one we should take note of. That sentiment is fine. However, the core inflation rate discussed by statisticians and their close cousins, economists, bears little resemblance to the one that is cursed by folk in the suburbs of Mansfield or Walsall. For the spreadsheet-fluent numerati, core inflation is a means to pursue an intellectual end; for most people in the UK, core inflation is of the ‘cor blimey’ sort or something worse, a means to make them poorer.

It is easy to be cynical about statisticians’ current obsession with core inflation. After all, it shows the UK’s inflation rate running usefully lower than the headline rates. For the 12 months to January, UK inflation, as measured by the officially favoured CPIH index – consumer prices with housing costs included – was cantering at 8.8 per cent. Other headline rates showed the consumer prices index galloping at 10.1 per cent, while the much-derided, but still widely used, retail price index was running wild at 13.4 per cent. No worries. Focus on what the UK state’s statistics provider, the Office for National Statistics (ONS), labels core inflation and the beast is almost back in the stable – trotting nicely at 5.3 per cent.

One problem is that the ONS’s choice for core inflation seems arbitrary. It actually produces 13 measures of core inflation – honestly – which attempt to answer the question, as posed by the ONS itself last autumn, “what part of each monthly observation of inflation is durable and what part is fleeting?” The ONS also acknowledges that interest in core inflation increases during periods of “higher inflation volatility” (ie, high inflation) and that core inflation data can be “contentious” and “unrepresentative”. Well, yes, as we’ll see.

Various statistical tools offer ways of extracting a core measure, whose aim would be to provide a signal capable of piercing the inflationary noise. For example, goods or services whose price changes are especially volatile might get a particularly low weighting in the basket of items used to measure inflation. Alternatively, extreme price changes might be excluded altogether from the index calculation. Such tweaks have their merits and limitations.

Despite these possibilities, the ONS appears to romp ahead and choose a contentious measure of core inflation as its favourite. It uses a variant of the CPIH that simply excludes the contribution of price changes in energy, food, alcohol and tobacco. No tweaking or trimming, it simply excludes these items, two of which – food and energy – simply could not be excluded from a household budget, and one of which – fuel – has a history of bouncing around erratically. Small wonder that the data for core inflation currently look as if the demon is under control.

 

Real-world inflation

This brings us to the other, and arguably bigger, problem – that statistics sometimes have limited relation to real life. Thus the ONS’s notion of core inflation bears little relation to the inflation that is crucial to consumers – the inflation rate that captures the cost of the goods and services that, like it or not, they simply cannot avoid; the rate that hits them in the bank account.

Hence the charts and the table, which show the performance and some details of what we have labelled ‘real’ core inflation, as opposed to the ‘fake’ core version that the ONS provides. As Chart 1 shows, the ascent of real core inflation since late 2021 has been pretty well vertical. Currently, it has burst through the top of the chart and is running at over 35 per cent.

BREAKDOWN OF INFLATION RATES
Inflation rates*FoodClothingTransportFuels'Real' Core'Fake' CoreCPIH
Current rate16.86.23.488.535.25.38.8
Average2.7-1.63.66.33.32.52.8
St'd dev'n3.43.83.214.05.41.82.0
Highest16.99.815.188.936.29.49.6
Lowest-3.3-10.4-2.8-8.7-2.80.50.2
*Percentage ch on 12 months, 1989-2023. Source: ONS & Investors' Chronicle

As to the components of real core inflation, as we say, they are the items of household spending that can’t be avoided. Sure, we can all wear an extra layer of clothes, trade down the weekly groceries shop from Waitrose to Lidl and all the rest of it. But this is core spending that might be reduced but can’t be sidestepped, which is why the measure of its price changes is real core inflation. With their weightings in the real core index in brackets, the components are: food (41 per cent), clothing (9 per cent), housing costs (21 per cent), health (4 per cent), transport (8 per cent), fuels (17 per cent). The weights follow the lead provided by ONS data for its CPIH indices with a bit of fine-tuning based on spending in the Bearbull household.

Is it an exaggeration to say the findings are astounding? Granted, any inflation index that has the cost of domestic gas and electricity as a substantial component will currently show a rapid rate. Yet it is also worth stressing that the real core index is not the result of data mining. The chosen components were the intuitively obvious selections, subject to no revisions, and their weights were driven by ONS figures. Once those two factors – components and weights – were in place there was no further fine-tuning.

Arguably what’s most interesting is not the way that real core inflation is behaving at present but how it has behaved since the global financial crisis of 2008-09. Chart 2 shows that it trailed both the CPIH index and its core inflation offshoot for the best part of 20 years leading up to that crisis. Switch attention back to Chart 1 and it becomes clear that real core inflation dug deep into consumers’ bank accounts both during the financial crisis and afterwards. True, there were periods when inflation turned to deflation – 2015-16 and again in 2020 – and consumers effectively got a windfall pay rise, but they were short-lived. Besides, as Chart 2 also shows, those days are past and won’t come again soon, even if fuel costs start falling sooner than we imagine.

Perhaps real core inflation even offers an insight into the disgruntlement that permeates not just the UK but most of the western world. Perhaps it tells us that benign rates of headline inflation mean little when, running within them, there is an insidious inflation at work. Perhaps it serves as a useful reminder of the damage to the social fabric that inflation can – and does – cause. Perhaps none of those. Whichever, it seems that core inflation of the cor-blimey sort is worth keeping under watch.

 

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Bearbull portfolio update

Once is happenstance. Twice is coincidence. The third time it’s enemy action, the baddie, Auric Goldfinger, told James Bond. Where crooks instinctively see enemies, the rest of us simply see a pattern emerging. So I wonder, are we seeing a pattern shaping up in the takeover game for London’s cheap listed companies?

Raising hostile offers is quite normal; not so raising recommended ones. The happenstance was the bidder for funerals’ operator Dignity (DTY) raising its offer between the directors’ provisional recommendation in January and the formally recommended offer this month. The coincidence is the upwards revision, last week, of a recommended offer for sausage-skin maker Devro (DVO) just as shareholders were about to vote on it.

Confirmation of this pattern is yet to emerge, although a higher offer for Dignity seemed the more likely of these two instances, even though the bidding parties own nigh-on 30 per cent of Dignity’s equity. Their original offer – 525p per share in cash – had the feel of Scrooge. Not that the formal offer – 550p cash – looks generous. It is not that Dignity’s share price topped £28 in 2016, that was a world ago; more that it’s feasible to see per-share value exceeding £10 if Dignity can get its house in order and lose most of the £525mn debt that encumbers it. The big question for outside shareholders is whether they should go along for the ride since the offer includes two alternatives – either a stake in Dignity’s would-be unlisted parent company or one in a listed investment company, Castelnau (CGL), whose major holdings are stakes in Dignity and models’ maker Hornby (HRN).

Not the most thrilling choice, but a choice nonetheless, which is more than will be offered to shareholders in Devro. Some of them were agitated enough to squeeze an extra 4 per cent from its putative parent, a privately owned Dutch company. As a shareholder in Devro, Bearbull is thankful for that, though – frankly – I would have preferred to see the company remain publicly owned. Still, while I contemplate how to invest the takeover proceeds I can also wonder, which Bearbull holding will be next?

bearbull@ft.com