by
Dr. Stephen Nash | May 22, 2013
Introduction
Inflation means different things to different people. Specifically, it can be observed that expenditure categories can vary dramatically, depending on relative income levels, as essential items make up a higher proportion of expenditure for lower income groups. This observation is supported by a recent UK study, which will be referred to as the IFS report.[1] In this piece we will cover the following main topics:
- some preliminary matter in the IFS report,
- inflation basket changes in the UK,
- inflation basket variations , and
- The outlook for energy prices.
Finally, we draw these various arguments together, as they specifically relate to investment planning.
Preliminaries
Inflation differs in the UK to inflation in Australia, for a variety of reasons, yet commonalities also exist. Specifically, the observation that less wealthy families have very different spending patterns from the very wealthy is similar between the UK and Australia. In order to review the variation in spending the authors of the IFS report do two things:
- First, the UK researchers classify spending into 12 categories: food, alcohol and tobacco, water, household goods and services, personal goods and services, public transport fares, catering, housing, domestic fuel, clothing, motoring, and leisure goods and services, and
- Second, the UK researchers split households into 10 equally sized income groups (referred to herein as ‘deciles’).
Inflation basket variations in the UK
After these preliminary matters, the IFS report shows the rather striking variation in expenditure patterns, across asset classes, as shown in the Figure 1 Below. Essential items, such as food and fuel comprise a much larger part of spending for lower income groups, when compared to high income groups.
Figure 1 shows, the approximate weights for the highest decile of income in the UK,
Figure 1 (Source: IFS Report, p.13, Figure 2.2)
In contrast, Figure 2 shows the spending pattern for the lowest decile,
Figure 2 (Source: IFS Report, p.13, Figure 2.2)
Notice how the dark blue part of the pie chart, the volatile part that is influenced by variations in food and fuel, changes rapidly, from the highest to the lowest income decile. Figure 3 summarises the differences, which are quite large,
Figure 3 (Source: IFS Report, p.13, Figure 2.2)
Australian inflation basket presentations
Data on the variations in the CPI basket for each income level in the case of Australia, as we saw with the UK, is difficult to find. However, the ABS does show the variation in spending patterns using the household type (see figure 4 below).
Figure 4 (Source: ABS, Table 3, Cat 6467.0)
Notice in Figure 4 how the allocation in the employee type to food is around 17%.
Now, notice in Figure 5 below, that this allocation significantly rises to 22% in the pensioner household type.
As income declines from the employee household type, which is related to the accumulation phase of investment, to the pensioner type which is related to the retirement phase of investment, one can notice that spending on food increases significantly. While direct fuel spending is not seperated as clearly as in the case of the UK, it is possible to suggest that the patterns that are evident in the UK in terms of the allocation to food spending do appear to be somewhat common to Australia.
In other words, the transition from accumulation to retirement is typically associated with a fall in income, and with that fall comes a change in the basket that the retiree faces. Not only is that basket more dominated by basic items like food and fuel but those items are more volatile in price than the rest of the CPI basket.
Figure 5 (Source: ABS, Table 3, Cat 6467.0)
Further, the RBA tends to focus on core measures of the CPI, not the volatile parts that feature in retirement spending. While one can understand that the RBA focuses on the non-volatile part of the CPI, this remains cold comfort for the retiree, who faces greater exposure to food and fuel as income falls.
Outlook for gas and electricity
If energy is of higher relative importance to those in retirement compared to those in employment, then the outlook for energy prices is important. In the UK study the IFS quote the UK department of Energy and Climate Change (DECC), who expect a continued appreciation of energy prices, although the data is now a little dated.
Figure 6 (Source: IFS Report, p.9)
While FIIG does not predict large increases in fuel price, as part of the expected investment scenario, FIIG has already pointed out the risks to oil price from tensions in the middle-east. As we pointed out recently, several factors are promoting the risk to the upside in the oil price which has recently remained firm in the context of a strong USD. The following are a list of those factors:
- Israeli fears about Iranian nuclear capabilities,
- Weapon transfer in Syria,
- Israeli involvement in the Syrian conflict, and
- Possible involvement of others in Syrian conflict, such as Turkey.
Importantly, the recent visit of the US president to Israel is a sign of how seriously the US administration is taking the current tensions in the region.
Conclusion
If inflation is not on your mind, as an investor, then it should be.
Importantly, this note indicates that inflation is not a fixed target; it changes with income. Lower income means a more volatile basket will be chosen compared to the situation when higher income is enjoyed. As one plans for retirement, then one needs to take this fact into account, and this makes the need to insure against inflation all the more relevant. Just as you intend to relax in your retirement, variations in the more volatile parts of the CPI will impact you, as a retiree, more and more.
While the RBA focuses on headline inflation, large rises in essential items impact those who can least afford it the most, and rises in food and fuel may not, necessarily, translate into core inflation. In other words, even though core inflation may stay in a range acceptable to the RBA, headline inflation may be elevated for some time primarily due to increases in food and fuel. If that scenario proceeds, then those on lower incomes, especially self-funded retirees and pensioners, will be impacted most. This makes the case for the purchase of inflation linked bonds (ILBs) even more important than previously thought. ILBs protect the retirement income stream from the ravages of inflation, and thereby deliver a product that all retirees both need and deserve.
[1] IFS Commentary C119, “The Spending Patterns and Inflation Experience of Low-Income Households over the Past Decade”, Peter Levell and Zoe Oldfield, Institute for Fiscal Studies, ISBN: 978-1-903274-83-5, June 2011, London.