Profound Changes

Remember that these profound changes would occur even though nothing in the real world has changed. Of course, a government genuinely committed to economic rigor would respond to statistical manoeuvres of this sort by reducing its inflation target by theexact amount of the statistical change, and then leave the rest of its macro-economic policy unaltered. But could any real life politician be so pristine?

Enough of this idle speculation. What, in reality, is the likelihood that Dr. Greenspan's 1 per cent could apply in the UK? There are in fact three main reasons why the retail price index might be over-estimating the rate of inflation.

THE SUBSTITUTION EFFECT: Over time, consumers naturally gravitate towards goods which are falling in price relative to the average. If the price index is based on historical weights, it will not make sufficient allowance for this trend, so it will give too much weight to goods which are becoming relatively more expensive. In the UK, we change the weights each year, so this is unlikely to be as much of a problem as it is in the US, where weights are altered only every few years.

THE QUALITY EFFECT : The goods included in the RPI obviously vary in quality over time. For the most part, quality improves - for example, a home computer in 1995 is a very different beast from its equivalent in 1985. The same applies to cars and most other consumer durables.

Although some economists believe that quality has declined in other categories, like clothing and footwear, the average quality of the entire basket of goods may well be improving by more than the statisticians allow. This imparts an upward bias to the price index.

THE DISCOUNT EFFECT: In real life, shoppers are increasingly hunting for bargains before parting with their cash. The amount they actually pay for goods is therefore not the full price on the ticket in the High Street, but the sales price in the discountstore.

But the statisticians have found it difficult to keep up with these new spending patterns. Although the RPI is based on a phenomenal 130,000 separate price checks each month, an increasing proportion of them may be in the wrong shops.

Again, this may be larger factor in the US than in the UK, where the trend to discount shopping has been slightly less pronounced.

Conventional wisdom among economists in the UK is that the sum total of these effects is not zero, but is probably not as large as it is in America, where estimates have ranged from zero to 2 per cent per annum. But the truth is that no-one really knows,since there has been no recent study of the size of possible biases in our inflation index.

The Treasury seems to be taking the issue seriously, and has asked the National Institute to conduct a review of the literature on the subject. But since inflation has now assumed such a dominant role in policy making, do we not owe it to ourselves to examine these distortions urgently?