Modelling Inflationary Outlooks

I'm not much of a budgeter in the sense of keeping meticulous records of spending and trying to keep to targets. Fortunately, in the past few years I haven't needed to be. Nevertheless, with my farewell to paid employment next year, I need to plan ahead and to be careful. One of my key tools is, unsurprisingly, the spreadsheet of income and expenditure. I do have reasonably good records for the past few years in the form of bank statements and credit card bills, so I can estimate our expenditure profile reasonably well (we use the CC only as a spending tracker and whenever we can -- it's a free service, after all).

I know, for example, that we spend about £2000 per month as a family of four living in a medium sized, Victorian terraced house. That includes just about everything (except holidays), namely: mortgage, council tax, energy, water, comms, insurance, necessary travel, food and drink, charities, entertainment, gifts, miscellaneous services and the obligatory £100 or so of unidentifiable "stuff" that I suppose leaks away from most households. There's scope for cutting back and, certainly, I was pleased to be able to reduce my buildings insurance this year by 70% and my nominal energy costs by 18%, but in the interests of domestic harmony other cuts are not imminently on the agenda. Ruling out unforeseeable family catastrophes, the question for me is, how are my income and expenditure profiles going to change over the next few years?

The biggest determinant will be inflation, so it's worthwhile modelling this and playing with the numbers. Obviously, assumptions will have to be made and these are mine. There are, of course, multiple inflations, but officially in the UK there are only two that really matter, CPI and RPI. The government has made its intention clear insofar as it is going to exploit the difference between them. Even if, at some point in the future, these measures are consolidated or further differentiated, I think the principle of the semi-official inflation wangle will still hold good in some form or other, so I am going with them for now.

CPI is a geometric mean that tends to minimise disparate sectoral inflation rates and excludes housing costs. It's well above target at the moment and for political reasons will probably remain so for a year or two, but I think it will be nailed to the target figure of 2% over the longer term. The reason for my confidence here is that it is the peg to which benefits and pensions will be fixed. Anyone with a defined benefit pension, public or private and regardless of what it says in the scheme rules, will find by legal strategem that it gets linked to CPI, not RPI. With the possible exception of the state basic pension (currently to be defined by an odd "triple lock", but that may change), all other state benefits will be linked to CPI by some kind of formula. Therefore, the pressure to keep CPI low will be immense. Accordingly, I have set any official family incomes to grow by CPI at 2%. Of course, the target may get lowered, but there's a limit to my pessimism.

Now for RPI. As an arithmetical mean, this reflects much more what we all experience and, despite the whingeing that goes on about the ONS tricks of the trade, such as discounting for increased functionality and so forth, I am prepared to accept it at face value. Obviously, I peg my expenditure to RPI, since even if I pay off the mortgage, I can't avoid council tax. What rate should I choose? Arbitrarily, I have chosen 5% as the long term average. Is this a good choice? Frankly, I haven't a clue. Direct energy costs, I think, will grow above trend and this will obviously drive up other stuff as well, but I assume that commodities and food will always cyclically attract production efficiencies at the right price (I am with Julian Simon and against Paul Ehrlich on that one, as is history).

Finally, and having roped off some capital for family educational developments, I have to assume what my investment returns will be. This will be a mixture of dividends, interest and capital gain/loss (I do not draw a hard distinction between capital and income). Based on a survey of my (admittedly rather poor) records, I've reckoned this, for now, at CPI+2%, which is about half my estimated returns over the past 15 years. Although this is a bit fuzzy, I think it is conservative and reasonable, since it is what I assume GDP growth will be over the long term. I see no point in imagining endless bear markets.

Having thus got my model, I am in a position to play with it. I've extended it out for 30 years, by which time I will either be dead or past caring. When you take that long term view, small changes to the parameters can have big effects. To give one example, altering RPI can be pretty scary. At 5%, I'm comfortable. At 6%, I'm feeling miserable (declining capital). At 7%, I'm spending my twilight years in soup kitchens (all money gone). On the other hand, at 3%, I could be funding soup kitchens, unless we are gripped by deflation, in which case, other parameters will have changed also. This is the beauty/ugliness of compounding. The other choices I have are to move to Mid-Glamorgan or, perish the thought, find a job.

I think this is an interesting exercise to do and, I hope, realistically based. I wonder what others are doing in this area? Are you modelling or relying on strategy for your future? If, on the other hand, you've decided to muddle through, is it because you've taken the (perhaps sensible) view that playing with numbers like this is all a bit silly? Merry Xmas everyone.