Inflation provides vital guide to the value of pound in your pocket

One word strikes fear into the hearts of consumers, investors, fund managers and economists more than any other - inflation. The average consumer hears and reads about inflation on a regular basis but few people seem to know how it is determined and what bearing it has on their lives.

Defining inflation: it can be described as a period when the price of goods rises while purchasing power declines. Deflation is when the reverse occurs. When there is high inflation on a constant basis the same item, such as bread, will cost increasingly more while every pound is continually worth less. This is what happened in the extreme during the 1970s when inflation, at one point, was running at around 20 per cent.

Measuring inflation: Many economies, including the Republic, measure inflation based on a national consumer price index (CPI).

Central Statistics Office (CSO) chief statistician, Mr Paul J. Crowley, says CPI measures price changes in the economy so it indirectly measures the value of the pound.

"It is not a cost of living index, which would include expenses and changes in people's income. The CPI is a pure price change measure," he said.

Items: To determine the consumer price index, the CSO chooses a basket of specific items purchased by consumers - small white sliced bread, a six-pack of beer, filtered cigarettes, men's shirts, central heating oil, mortgage interest and three-piece suites for example - and examines the price of each item.

In general, these consumer items are chosen from 10 main commodity groups: food, alcohol, tobacco, clothing and footwear, fuel and light, housing, durable household goods, other goods, transport, service and related expenditure. The specific items chosen remain fixed each month for comparison.

Prices: More than 45,000 prices are collected for 985 varieties of items from a fixed number of retail and service outlets throughout the State. Pricing takes place in 82 cities and towns in the Republic on the second Tuesday of each month. Personal visits are made to retail outlets to collect the data by 200 part-time pricers.

Weights: Once the prices are collected, the CSO places them into pre-determined weights, or percentages, within the overall index. These expenditure weightings are the way to express the importance of the amount spent on each item. For example, food composes 22.85 per cent of the index while household durables compose 3.58 per cent.

Once weighted, the figures are compared to the cost of a price basket at another pre-determined time. Currently, the results are measured against November 1996 prices, reflecting consumer patterns up to the beginning of 1997.

Although this is a simplistic description of inflation and how it is measured, increased inflation has an immediate effect on consumers and investors.

Effect on consumers and investors: when inflation is high, items become progressively more expensive to purchase. Investments are also affected by inflation. Some £1,000 invested today will not have the same buying power in 10 years. Therefore, it is important that an investment's rate of return keeps up with inflation.

A deposit account returning 5 per cent a year is not really returning that amount when inflation is taken into account. To determine the real rate of return, investors should subtract the inflation rate from the nominal rate of return. The real rate of return for a deposit delivering a nominal rate of 5 per cent a year when the inflation rate is 3.4 per cent is only 1.6 per cent a year.

Current rate of inflation: The rate of inflation in December was 3.4 per cent, its highest level since 1993 when prices rose in the aftermath of the devaluation of the pound. This means the inflation rate has effectively doubled in just two months, causing a great deal of alarm among economists. Many forecasters are expecting inflation to edge up to 4 per cent in 2000.

The main reason for the increase in December prices was the Budget announcement of a 50p price rise for a pack of 20 cigarettes. As cigarettes are included in the CPI and are weighted, this price rise alone was responsible for a 0.8 per cent of a percentage point rise in the index, accounting for the bulk of the 1.1 per cent point monthly rise. Rail and bus prices, oil prices and drink prices in pubs also rose in December, pushing inflation rates higher.

The latest rise has led to warnings of a sustained pick-up in inflation, fuelled by a weak euro and strong spending, which has lead to demands for higher wage increases as part of a new national agreement.

Membership of the euro zone is also contributing to inflationary fears as the low interest rates dictated across the euro zone are inappropriate for the booming Irish economy.

Normally, the Central Bank would have the discretion to increase interest rates to cool an overheating economy. An increase in interest rates naturally cools consumer lending demand for items like homes, cars and foreign holidays.

Irish inflation is now the highest in the EU compared with two years ago when the Irish inflation rate of 1.1 per cent was the lowest among EU member-states.