UK Inflation Rate – The Affect of Compounding

We have all see the annual % change charts for inflation (both RPI and CPI in the UK),  just like the one shown below.  But have you ever really considered what those small differences between the % change in CPI and RPI means over the long term? 

From http://www.bbc.co.uk/news/10612209

Do you realise that over 10 to 20 year the compounded effect of those differences in the % change reported for RPI compared to CPI make a very big difference.  The easiest method to show this effect is to compare the RPI and CPI indexes.  An index will clearly shows the compounded change over time from the base year.  The guys over at www.inflationarypressure.com have added a number of new charts and one in particular caught my eye.  This chart plotted the RPI index vs. CPI index since 1987 (shown below).

Historical RPI and CPI index data since 1987. Both index to January 1987 = 100.
From: www.inflationarypressure.com

This clearly illustrated the affect of compounding all those small % differences between CPI and RPI.  Over 24 year the RPI index has rose by factor of 2.4 whereas the CPi index has increased only by a factor of 2.

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Updated Inflation Adjusted Gold Price - US Dollars and UK Pounds

Have recently found price inflation estimates for the UK and US back to 1900.  So I thought that I would extend the inflation adjusted historic gold price in UK Pounds and US Dollars from my original blog on the historical price of Gold, all the way back to 1900.  Below are the historic annual average inflation adjusted gold price in US Dollar and GB Pounds: 

        Sources: Gold World Gold Council,   US inflation Consumer Price Index (Estimate) 1800-2008, 

                      UK inflation Inflation: the Value of the Pound 1750-2002.

The doted lines are the unadjusted annual average gold price, and the sold lines are the inflation adjusted gold price.  The extended time allows us to examine the long running average inflation adjusted gold price.  The first thing that becomes obvious is that the piece gold bottomed out at during the late 1990’s was pretty close to the inflation adjusted price in the 1920’s, 1950’s and 1960’s for both $’s and £’s.

The second thing that you notice is that in the inflation adjusted gold price was from 1900-1915 and in the 1930’s were very close to that the early 1990’s.  The price at these times was very close the long running inflation adjusted average of US $483 per troy ounce and UK £344 per troy oz.  Below is inflation adjusted gold price index at 1948 = 100 (the same baseline used in the previous blog entry). 

Here you can see that there was a sudden blip in the inflation adjusted price of price of gold in UK £.  This was a bad economic period for the United Kingdom and the Pound Sterling was devalued in 1949.  So this is probably not the best time period to index to inflation adjusted gold price to.  Further examination of the first chart reveals that the 1900’s has a relatively stable inflation adjusted gold price in both Dollars and Pounds.  So the year 1900 was chased as the base to index the inflation adjusted gold prices to and the results are shown below: 

It is interesting to note the compounded rate of change for the inflation adjusted gold prices in Dollars and Pounds tracked each other very closely for the majority of the 20^th Century.  There were a few periods when the inflation adjusted gold price index in Pounds was substantially above the Dollar equivalent.  The longest period was from the late 1940’ until 1970.  The other times were for a few years in the early 1970’s and early 1980’.

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Inflation Adjusted Historic Gold Price - US Dollars and UK Pounds

You may have often heard it banded around over the last couple of years that Gold is an "Inflation Hedge" against unforeseen disasters since physical gold is one of the few investments that is not simultaneously an asset and someone else's liability.  In other words as it’s a real asset, where the total quantity can’t easily be altered, it keeps its true purchasing power.  Unlike paper money which can be magic out of thin air (and is at this very moment).

It has often be quoted that a pair offhand crafted quality sandals during the Roman Empire cost an half an ounce of gold, which is very similar to the price of ladies must have designer shoes today, coincidence?  With all the talk about the inflation adjusted price (also called the real price) of gold reaching levels we haven't seen since the 1980 peak.  I thought that I would investigate the subject from a UK inflation hedge perspective.

As gold like all commodities are traded in US Dollars.  So for any non US investor it immediately apparent whether it’s value has really increased decreases or stayed the same in your local terms.  The average price of a troy ounce (which is equal to 31.1034768 grams and 1.09714 avoirdupois / imperial ounces) in 2010 was US $1,224 and GB £792.  

The annual average price of gold for most major currencies is published by the World Gold Council at www.gold.org/investment/statistics/prices.  Taking this data and adjusting it for the affect of inflation by converting the price equitant in 2010 US Dollars and 2010 GP Pounds Stirling you get the results shown in the graph below (using the All Urban Consumers (CPI-U) from the US Department Of Labor for the US inflation and the Retail Prices Index (RPI) all items, from the UK Office of National Statistics for the UK inflation). 

Inflation Adjusted Gold Price in GB Pounds and US Dollars since 1948

The doted lines are the unadjusted annual average gold price, and the sold lines are the inflation adjusted gold price.  The first thing that becomes obvious is that the piece gold bottomed out at during the late 1990’s was pretty close to the inflation adjusted price in the 1950’s and 1960’s for both $’s and £’s.  The second thing that you notices is that in the 1950’s and 1960’s the gold prices was virtually the same in Dollars and Pounds (parity), until the early 1970’s, where upon they diverged.  From that time onwards the Pound value is always lower than the Dollar value. These observations can be seen easier when the inflation adjusted gold price is index from 1950, as illustrated in the in chart below.

Inflation Adjusted Gold Price in GB Pounds and US Dollars. Indexed from1948.

As indexed data highlights the compounded yearly changes really well, those observations now become very clear.  The next question that springs to mind is why did the inflation adjusted price of gold start off at parity in Dollars and Pounds and then why did it diverge?  It must be remembered that the exchange rate between the £ and $ use to be much greater then it is at present (£1 ~ $1.60).

Food for thought don’t you thing?  I’ve have to see is I can find UK inflation rate date back to the 1900’s, too see what the inflation adjusted gold price was in Pounds back during the 1920’s and 1930’s.  The last big credit boom and bust that everyone keep refereeing to!

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So What do the Inflation Numbers Really Mean?

Its the middle of the month and TV news reports are all about price increases.  So it must mean that the official UK inflation figures for the previous month have been released.  You see a fancy chart from the Office of National Statistics showing CPI yearly percent changes over the last 18 months (as shown by the chart below):

From the ONS Statistical Bulletin - Consumer Price Indices August 2011,  

http://www.ons.gov.uk/ons/dcp171778_231780.pdf

But what does that really mean to me in my everyday life?  Whats the context, how is the inflation rate to wages?  How have prices change over the years?  Over the long term are things cheap, but now increasing fast or what?  And where do you find that sort of information, particularly for UK data and not just US data?

Well, having trawled through the internet over the years i have come across the odd nugget of information on inflation adjusted data or charts for the odd commodity like corn or oil.  There are often interesting and thought provoking, but not that relevant to me as its always US data in $ (a good example is the chart below):

US Inflation Adjusted Price of Corn in US Dollars

 

However a new website has just come on-line the other week with UK inflation data since 1987 (www.inflationarypressure.com).  They have the ONS inflation data for 50 everyday items and average wages in one single location. But even better than that, it all index to the same point in time making it straight forward to start analyzing the charts straight away.  Much easier than hunting around on the ONS website for hours, finding a bit here and a bit there and having to piece it all together.

Here is one of the interesting things I found out that i didn't know before.  The inflation report for August 2011 in the UK, reported that the rising cost of energy prices were one of the causes to the increasing inflationary pressure on families finances.

From the data and charts from www.inflationarypressure.com you get the chance to put price changes for electricity into context.  When you comparer the average electricity and gas prices against average wages since 1987 you see an interesting trend.  Electricity and gas prices flatlined from the early 1990’s to around 2006 (see the two charts below):

A chart illustrates how the price of electricy in the UK has changed against average salary from Jan 1987

A graph illustrates how the price of natural gas in the UK has changed against average salary from Jan 1987

Therefore, when compared to wages, the long term the current price of gas is similar to 1987 and electricity is actually cheaper compared to1987.  Is the real problem that we have become addicted to unusually cheap energy?

Written by Inflation Monkey. Join on Google+.