Hamish McRae: The madness of our inflation indices

So inflation falls to zero, the lowest since 1960. Meanwhile, the Governor of the Bank of England has to write a letter to the Chancellor explaining why inflation is too high. Um. Something not quite right here. What is not right is that both of the two main measures of inflation, the retail price index and the consumer price index, are flawed. The RPI (which says inflation is zero) has the great advantage of being continually calculated back to 1947. It is trusted, it is independently calculated and it cannot be massaged by the government of the day. It is also the basis for calculating state and all index-linked pensions, welfare benefits and the return on index-linked government debt. So it is hugely important.

It does, however, have one grave flaw. Its calculation of housing costs takes into account the interest on mortgages. That has the advantage of reflecting the monthly cost of living for people with mortgages, but it leads to exaggerated swings in the index such as we are seeing now. Any inflation index that goes from 5 per cent to zero in six months, as the RPI, is going to mislead.

The alternative CPI (which says inflation is 3.2 per cent) has the advantage that it is harmonised with the indices of other EU members – it used to be called the harmonised index – and it is more stable. It is used by the Bank of England as the rate to target, with the range set at 1 percentage point above or below a central point of 2 per cent. Because it is now above 3 per cent the Bank has to say sorry and explain what it is doing about it.

The CPI's gravest flaw is that it hardly takes into account housing costs at all, which is why it is going up when the RPI is gong down. Not counting housing costs might seem a rather serious omission but, unfortunately, the European statisticians cannot agree on how to include them and, until they do, nothing can be done about that. So the Bank has to use an inflation target which does not include housing. That is ridiculous and it protested about it when the target was imposed by Gordon Brown but it lost the battle. Actually, there is a better inflation measure, the RPI calculated to exclude swings in mortgage interest rates, which the Bank used to use as its target measure. This is clumsily labelled the RPIX.

You want to know what it is? Well, last month it was 2.5 per cent. That happens to be dead centre of the old range at which it was required to keep inflation. If the Government had not changed the target measure, there would be none of this nonsense about writing letters to the Chancellor.

So is everything on the inflation front really hunky-dory? Unfortunately not, and for at least three reasons. The first is that the present situation is very unstable. The price of some things is collapsing while the price of others is still climbing sharply. For example, the price for a new car is well down on last year because the dealers are desperate to shift stock. Office rents are coming down because of the fall in demand. The shops are full of Bogof (buy-one-get-one-free) offers.

As for mortgage payments, they will go on coming down for a while yet as the cuts in rates feed through, but they cannot stay down for that long because the lenders have having great difficultly attracting deposits at such low rates. So the situation is not sustainable. This fall in inflation, as measured by the RPI, does not reflect the real cost of producing the goods or services. When demand picks up, so too will inflation.

Meanwhile, there are already strong countervailing forces, as reflected in the CPI. The fall of the pound is pushing up import prices and we import a lot of stuff. As energy prices recover, that will feed straight through too. We have gone from inflation to deflation but could swing back just as fast.

The second reason is that the way inflation has worked out adds tremendous pressure to public finances, already shattered by rising spending and falling revenues. The Government has to put up pensions and other welfare payments by 5 per cent, the RPI last September. But the money on VAT is coming in on prices that are flat or down year-on-year. Even if it hadn't cut the rate it would still be getting in less money. Add in the impact of zero pay increases (except for public sector workers) and the Government will probably have to face falling revenues for some time even after demand starts to recover.

There is a third concern and it is that a world of falling, but uncertain, prices is a world unconducive to growth. At its simplest, anyone seeking to buy a new product will gain by waiting a few months until the price is lower. So falling prices change the dynamics of the market, as we have seen most notably in housing. That has a generally depressing impact on demand, as Japan experienced in the 1990s. The RPI will almost certainly go negative in the coming months and that will be disruptive to industry, commerce and trade. That is why the Bank of England and other central banks are desperately trying to create inflation by this "quantitative easing" and other means.

Eventually they will succeed. Pump in enough money and it will eventually find a home. Prices will start to go up, maybe quite sharply, and we will be into having to have higher interest rates to choke the rise off again. It will be a case of deflation now, inflation later. One of the prime worries must be that we will have to start putting up interest rates before the recovery is assured. We may have to put up long-term rates simply to attract enough money to fund the Government's deficit.

You see the point. Inflation overall, if measured sensibly, appears relatively stable right now. But there are massive forces on either side, pushing it up and down. In the months ahead, the chances are that first the deflationary forces will gain the upper hand and then eventually the inflationary ones will win. The trouble is that this battle will be bad for economic confidence. It is hard to plan when you don't know what is going to happen to prices. And so, while the overwhelming probability is that there will be some sort of economic recovery next year, it will be fragile and fraught. Stability matters and there is not much of it about.

h.mcrae@independent.co.uk