How does UK inflation work? ONS process for calculating cost of living through CPI and RPI explained

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The UK cost of living crisis has been fuelled by soaring energy bills, petrol costs and food prices, as well as a real-terms drop in wages and spending power

The cost of living crisis showed further signs of easing in July 2023, as UK inflation fell again to 6.8%.

The latest ONS Consumer Prices Index (CPI) showed prices were continuing to rise, albeit at a slower pace. It came a day after official labour market statistics showed wage growth had almost caught up with inflation - a change that means purchasing power could soon begin to grow again for the average worker.

But while the picture looks rosier on the face of it, the data has some troubling developments hidden within it. Core inflation - a measure of how embedded price rises are in the economy - remained static at 6.9%. It means inflation - and the wider cost of living crisis - may have become sticky.

It could mean the Bank of England raises interest rates in September for the 15th time in a row. The central bank’s main target is to reduce inflation to 2% - a rate that’s deemed to be more economically sustainable.

But how is inflation calculated - and what exactly does a high rate mean for you?

What is inflation?

Inflation is an economics term for the rate of price rises across the economy. Price rises tend to come about when demand outstrips supply, with key drivers of the current crisis including, the price of oil, supply chain disruption, Brexit-related labour shortages and low product availability.

Essentially, anything that hikes the cost of creating a product and getting it from A to B is likely to increase inflation. One factor behind the recent high rates is the Russia-Ukraine war as both countries are key suppliers of vital commodities, like gas and wheat. While the economic shocks of the conflict have now fallen out of the data (inflation is typically displayed as an annual figure), there is an argument that interest rates are now bleeding into inflation figures given higher rates can be reflected in costs covered by the Consumer Prices Index - e.g. car rentals.

Sharp rises in inflation can severely impact the cost of living and see consumers opt to reduce their spending - especially on non-essential items. Overall, this is bad news for the economy, which is already struggling to grow in 2023. When inflation is at low levels, it is seen by most economists as a good thing. They believe it encourages shoppers to spend rather than run the risk of seeing the value of their money decrease. The Bank of England, which aims to control inflation by using interest rates, has a target of keeping the rate of price rises to 2%.

The thinking is that this contributes towards a healthy economy, where people spend their cash and create more demand for goods and services by doing so, which maintains supply chains and employment. If there was deflation, it is believed consumers would not feel the need to spend as much right away because their purchasing power could extend further in the future.

One key thing to note with inflation is that even if the rate is going down, prices are still rising on average. Given prices were already rising this time last year, the percentage increase you see today should be viewed as being in addition to the percentage increase recorded last year (10.1% as of July 2022).

Also, as the headline inflation figure is an average, some categories will be recording bigger price rises, while others will be seeing lower ones (or even deflation). For example, while food prices have got 14.8% more expensive, while transport costs (including fuel prices) have reduced.

Any decline in the inflation rate can also be down to the way it is calculated. Given the headline rate is an annual comparison, when any major price shocks move out of the 12-month window of measurements, the rate is likely to go down. This is why inflation fell so sharply in April - the Ofgem energy price cap increase of April 2022 was not matched by the bill increases of April 2023.

Research has indicated that the cost of living has risen much more for those on the lowest incomes. Analysis by progressive think tank the Resolution Foundation has found the poorest tenth of the UK population are seeing price rises that are 2% higher compared to the country’s wealthiest tenth, as they tend to spend a greater proportion of their income on basic necessities.

How is inflation calculated?

The UK has two mechanisms for calculating inflation which are worked out by official statistics body the ONS every month. This data not only allows people to make informed decisions about their spending habits but it is also used to set state handouts, like pensions, benefits and statutory sick pay.

CPI

The most important measure of inflation in the UK, and internationally, is the CPI. Used as the UK’s official inflation yardstick, it’s worked out by measuring the price of a typical ‘basket’ of goods and services we use in our everyday lives.

This basket includes everything from the price of a loaf of bread to how much an e-book costs and is determined by the annual Family Expenditure Survey, which is completed by 6,000 people and determines the percentage of people’s incomes that are spent on different things. It changes every year, with items added or taken away to better reflect current shopping habits.

This list often provides a fascinating insight into UK social trends. For example, in 2023, E-bikes, home security cameras and frozen berries have all been added, while non-Top 40 CDs, alcopops and digital cameras have been removed.

The ONS weights each product or service category depending on its importance to the average person’s budget. It means things that are integral to our lives, like food, have more of a bearing on the CPI rate than luxuries, such as alcohol.

In all, the ONS gathers 180,000 individual prices for more than 720 consumer goods and services every single month. These prices are collected in roughly 140 locations across the UK, as well as from the internet and over the phone.

Every year, the ONS measures inflation using a typical ‘basket’ of goods and services the average household spends money on (image: Adobe)Every year, the ONS measures inflation using a typical ‘basket’ of goods and services the average household spends money on (image: Adobe)
Every year, the ONS measures inflation using a typical ‘basket’ of goods and services the average household spends money on (image: Adobe) | Adobe

Percentage increases in price are then multiplied by the weighting the particular product category has been given, which gives us a picture of how much of an impact it is having on consumer budgets. The September edition of the CPI tends to be especially important because the government uses it to judge how much state benefits should increase from the next financial year.

The ONS also calculates a version of the CPI that includes home owner occupier costs and council tax (CPIH). While it is a more comprehensive measure of overall inflation, it masks day-to-day consumer price changes because housing is given a huge weighting. It also makes it harder to make international comparisons, as the UK’s housing system is very different from those in other countries.

RPI

Alongside the CPI, the ONS also calculates inflation through the Retail Prices Index (RPI). However, it is not used for official purposes as, by international standards, it is seen as an inferior measurement to the CPI.

Train ticket prices are set using RPI (Pic: Getty Images)Train ticket prices are set using RPI (Pic: Getty Images)
Train ticket prices are set using RPI (Pic: Getty Images) | Getty Images

The reason why it is still calculated is because it provides a historical yardstick for how UK inflation has changed. This is because it was used for much of the twentieth century. RPI is still used to determine some UK prices, for example train tickets, mobile phone bills and some taxes, like alcohol duty. It fell to a rate of 9% in July.

What does the current CPI mean?

The CPI rate was6.8% in July 2023. What this means in practice is that the average price of goods and services cost 6.8% more than in July 2022. In real terms, an item that cost £1 last year now costs an average of £1.07 (when we round the figure up). And even though the rate’s reduced compared to June, it still means prices are going up.

Ultimately, it all means the purchasing power of the pounds in your pocket has diminished significantly since before the cost of living crisis began two years ago. This level of inflation builds on what was already a high rate of 10.1% in July 2022.

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