Despite another fall in the inflation rate the government’s own forecasters expect no improvement in real living standards for most people before the end of the decade writes James Meadway

Inflation, on the official figures released this morning, has fallen once again. The Office for National Statistics now believes that average prices are rising at a rate of only 1.7% over a whole year, down from 1.9% last month.

This is a very low rate – below the Bank of England target of 2%, and the lowest in this country for four years. There are two points to make on this. First, low rates of inflation are not entirely good thing. In particular, they are bad for economies lumbering under a heavy load of debt. The problem is that debt is paid out in money, and has to be paid back in money.

If inflation is high, the real burden of this debt falls over time since, in effect, the value of the money that is to be paid is falling. But if inflation is low – or even negative, with prices falling over time – the opposite effect occurs. The real burden of the debt gradually increases: business owners facing falling prices find paying their debt harder; workers see their real earnings fall, and find paying the debt harder. As prices fall, a process of debt deflation kicks in – falling prices increase the real burden of debt, dragging economic activity further downwards, pulling down prices and so further increasing the burden of debt – a terrible vicious circle, in other words.

Britain is not, yet, in negative inflation – unlike some Eurozone members. But it is just about the most heavily-indebted developed economy in the world. This is not the result of government debt, which, despite much rhetoric, is not particularly high. It is the extraordinary burden of private sector debt, made up of households, firms and – especially – the monstrous liability of our financial institutions. Low inflation rates, in an economy as debt-burden as this one, are not welcome.

There is, however, another, perhaps more pressing concern. Rising prices means, in general, falling living standards: as prices go up, earnings need to rise, too, if people are to keep buying the same things as before. For the last few years, price rises have been way above rises in earnings for most people. The result has been the longest sustained decline in living standards certainly since official records began in the 1960s, and most likely (looking further back) since the 1870s.

The official measure of inflation, the Consumer Price Index (CPI) is supposed to capture what an “average” household would buy. On the basis of the prices in this average “basket of goods”, the overall inflation rate is calculated. So what goes in, and what is left out of this “average” basket of goods will affect the rate of inflation.

CPI has replaced, as the preferred official measure, the earlier Retail Price Index (RPI). RPI differed from CPI in a number of ways. (For a much more detailed explanation, see this clear account.) Amongst other things, it excluded the consumption of the top 4% of earners, on the grounds they were not exactly “average” consumers. And it included the costs of housing – clearly a major component of household costs. The government statisticians still calculate it, however, so we can see the difference.

CPI includes the top 4%, and excludes the cost of housing. It produces, as a result, a different measure for inflation. Typically, it is much lower: inflation measured by CPI is currently 1.7%, but under RPI it is 2.7%.

This matters if we think inflation should be working as guide to the cost of living. Earnings need to rise at the same rate to keep pace. This is pace is lower, if inflation is lower. The labour market has to do less work in providing jobs and consistent rises in pay if inflation is lower. What happens to both the rate of inflation and to price rises determines real living standards.

Tucked away at the back of last week’s Budget document were the Office for Budget Responsibility (OBR) forecasts. These tell us what the government’s official forecasters think is going to happen to the economy over the next few years or so. This is not an exact science, to put it kindly – as the late, great J.K. Galbraith put it, economic forecasts “exist to make astrology look good.” But let’s assume that something roughly along the lines that the OBR expect to happen will happen. If we do, an interesting story emerges. The table below shows real earnings calculated with the CPI inflation forecasts, and with the RPI inflation forecasts:

On the CPI measures, real earnings pick up again from next year. But on the RPI measure, this does not happen. Average real earnings fall, pretty much consistently, until the end of the decade. In other words, on the earlier measure of inflation, including housing costs (and excluding the top earners), the government’s own forecasters expect no improvement in real living standards for most people before the end of the decade – if at all. In hard cash terms, this is the difference between someone on the average wage today earning the equivalent of £1,596 a year more, or £485 less, by 2018.

This is a significant gap. It is the difference between an ongoing cost of living crisis, and a resilient economy. These two positions pretty much defines British politics at present, with the two main parties taking one side or another, and they are likely to do so until at least next year’s election. But a real difference hinges entirely, in the forecasts, on how we calculate inflation. Expect debates over the “true” cost of living to intensify.