Time to think again about the way we measure inflation?

As was widely expected, annual inflation increased again last month. A combination of the VAT rise and higher oil prices helped push CPI from 3.7% in December to 4% in January – twice the government’s official target of 2 per cent. The wider RPI measure also increased, from 4.8% to 5.1%.

There is, however, a big question over how accurately these figures capture the extent of the price increases in different households.

As reported by Larry Elliot and Simon Briscoe, some statisticians are concerned that official measures of inflation understate real trends in the cost of living being faced by consumers.

The problem goes beyond the government’s decision to shift benefit-indexing from the RPI to the lower CPI measure. It raises wider questions about how and why we’ve settled on these particular definitions of inflation in the first place. Our analysis at the Resolution Foundation shows that headline inflation figures fail to capture differences in spending habits – and therefore price increases – across different household types.

In recent years, rapid increases in the costs of staple goods such as food and fuel mean that the difference between the inflation faced by those in the upper half of the income distribution (higher earners) and those living in low-to-middle income households has grown. This reflects the fact that food and fuel account for a larger share of expenditure in lower income households, so when prices in these commodities rise, these households are hit particularly hard.

The chart below captures the cumulative impact of these varying spending habits on the purchasing power of different households over time:

From 2000-2006, the impact was fairly trivial: sometimes inflation was higher for low-to-middle earners, and sometimes it was lower – the cumulative impact on their spending power over time was negligible.

But since 2006, a solid gap has opened up in the impact of inflation on low-to-middle earners versus higher earners. Today, if low-to-middle earners had faced the same level of inflation as higher earners in the period since 2000, their typical annual basket of goods would cost about £155 less than it currently does.This is lower than the peak difference of around £300 reached in 2009, but it is still much bigger than the variation in inflation’s impact we saw in the first half of the last decade.

This all matters because government income-support mechanisms like tax credits are indexed to headline levels of inflation. As a result annual increases in payments are unlikely to have kept pace with real rises in the cost of living being experienced in low-to-middle earner households in recent years. The shift to the lower CPI measure from April will only make this situation worse.

And of course, the resultant squeeze on low-to-middle earner’s living standards is compounded by the fact real wages have been falling in the past year – average annual earnings growth stood at just 2.4% in November – and are expected to continue to decline until 2013.

For all the anxiety about headline inflation figures that will be voiced in tomorrow’s papers, the reality is likely to be worse for those on low and middle incomes.