Life After Full-time Work Blog

That’s because our spending patterns are different

Inflation has been highlighted in the news for what seems like a long time: since mid-2021, I think. It is one of the most misunderstood measures, in my opinion. Let’s examine what it is, how it’s typically measured, and why so many people complain about its magnitude even as it falls.

First, what is inflation? Very simple: it measures how quickly prices are rising. That’s important, because rising prices mean that the purchasing power of a unit of currency (one dollar, one pound, whatever) is decreasing.

It’s typically expressed in percentage points per annum. For example, an inflation rate of 3% implies that prices are rising at the rate of 3 percent a year. So a package that cost $100 a year ago now costs $103; or, if it’s a projection, a package that costs $100 today will cost $103 in a year’s time, if inflation continues at this level.

One common misunderstanding arises when inflation falls. Suppose it was 3% a year, and has now fallen to 2% a year. That doesn’t mean prices have fallen. In fact prices are still rising. It just means they’re no longer rising as fast as before. It’s as if prices measure your distance in a certain direction from your starting point, and inflation measures your speed. You may be traveling fast (high inflation), and then you slow down (so inflation, like your speed, is falling). But you’re still moving further away from your starting point (that is, prices are still rising). Politicians like to claim success when, for example, inflation falls from 6% to 2%, as if prices are now 4% lower than before. No, they’re not. They’re 2% higher than before. Your speed has fallen, but you’re still moving ahead.

Next, how is inflation measured? Easy, in principle: measure how much prices have changed since the last measurement. Ah, but that’s difficult – not just because you have to keep track of prices (for which mechanisms exist), but because different prices change at different rates. It may be, for example, that food prices have risen fast and that recreation now actually costs less than before, while rents are increasing but not as fast as food prices. In effect, the prices of three different products or services are changing at different rates. Which one measures inflation?

Answer: none of them, in the traditional measure. What is done is to consider a basket of goods and services, and measure the average rate of inflation for that basket. For example, the basket for the Consumer Price Index in Canada contains 8 major components: food; shelter; household operations; furnishings and equipment; clothing and footwear; transportation; recreation, education and reading; and alcoholic beverages, tobacco products and recreational cannabis. Of course, there are specific amounts of specific goods and services in each of the 8 major components. The prices are tracked every month, and the index is announced.

But wait, I hear you cry, those aren’t the things I spend money on, at least not in those proportions. Quite right, too. That means that the way that changing prices affect you is different from the way changing prices affect someone else, and both are different from the impact of the changing prices in the index. That’s what I meant in the title to this blog post: inflation is indeed different for each of us, because we have different spending patterns.

And that’s a reason why there are many different inflation measures.

For example, Canada also has a measure called “core inflation.” Take the components of its Consumer Price Index, and eliminate food, energy and the impact of indirect taxation: what’s left is called “core inflation.” Why bother with this? Because typically food and energy prices are more volatile than most other prices, so the balance is a sort of more stable “core”; and if you also exclude indirect taxes (GST, HST and so on), the rest becomes a (slightly) more stable measure that the Bank of Canada uses as its relevant measure of inflation, when it tries to influence the economy through its monetary policy (setting interest rates).

In the UK there’s a Consumer Price Index and a Retail Price Index. To me these names sound like they’re describing the same thing: if retail doesn’t mean what consumers buy, I don’t know what it does mean. Regardless, the UK uses those names. What’s the difference? The UK RPI includes mortgage interest payments, whereas the UK CPI doesn’t include any aspects of housing costs. So, which is more relevant? In a way, neither is relevant to any individuals or families, because their spending patterns (their basket of goods and services) will be different anyway.

And even then, it’s debatable how some costs are brought into the index. Housing might be the most obvious and significant example. Recently a highly intelligent and knowledgeable young man mentioned to me that he couldn’t see how the recent very rapid increases in house prices affected his country’s CPI. And he’s spot on, because house prices typically aren’t directly reflected in the CPI. Why? Because the CPI is intended to measure the prices of goods and services consumed, not investment values. The high price of buying a house is a reflection of investment value; the consumption value is better measured by rental prices, and rents often lag house price increases.

So the best we can hope for is to get a rough idea of the rate of change of prices in general. And, even then, not a rate that applies directly to us.

That’s why, recently, even though general inflation has been falling (which governments love to boast about), many consumers are still very angry, and don’t care about falling inflation (which, as we noted earlier, still means rising prices), because many grocery prices are still rising fast, and for those families, groceries are far more significant an item of spending than for most families. So they see inflation as still extremely high. In fact, they don’t care about inflation; they care about high prices.

Inflation may be a particularly difficult issue for retirees, for two reasons.

One applies if they’re on a fixed income, because then that fixed income purchases less and less as prices rise.

The other reason is that, in general, their spending patterns differ from those of workers. For example, in the US retirees spend a smaller proportion on housing than workers (though it’s still very high), but a higher proportion on healthcare; also a lower proportion than workers on transportation and clothing. Those differences are easy to understand, and the patterns may well be the same in other countries. The fact is, though, that the composition of the spending baskets are (on average) different for retirees and workers; and therefore, if in any country you were to calculate an inflation index based on (average) retiree spending patterns, it might well differ from the country’s more general inflation index.

And that’s done, though not publicized extensively. In Australia, for example, a study from 2007 to 2023 identified its overall CPI as averaging 2.70% a year over the period, while the inflation rate for the “Pensioner and Beneficiary Living Cost Index” averaged 2.86% a year – slightly higher than for workers. I remember another study (I confess I can’t find it, now – I think it was a US study) with much the same result over a long period: retiree inflation averaged about 0.25% a year higher than for workers. How much impact these differences might have on the case for building an official retiree inflation index that influences increases in government (or other) pensions in payment is anyone’s guess.

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Takeaway

Inflation means rising prices, and since we all have different spending baskets, inflation is different for each of us. A country’s Consumer Price Index is meant to very roughly represent the rate of increase in prices for the average consumer’s spending basket. Typically retiree spending baskets increase in price at roughly the same rate as (or perhaps a slightly higher rate than) for workers.

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