What is core inflation? Meaning of UK prices measure explained - why it is important for cost of living

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The Bank of England follows the core inflation rate closely, using it to set interest rates. It means the rate has an indirect effect on mortgage rates

There has been some good news for consumers as the UK inflation rate recorded another significant drop in July.

According to the Office for National Statistics (ONS), the rate of the Consumer Prices Index (CPI) dropped from 7.9% in June to 6.8% in July. It means price hikes are now running at their lowest rate since February 2022. The latest fall came as a result of the Ofgem energy price cap, which reduced energy bills by the equivalent of £426 a year from 1 July.

While a lower inflation rate means our purchasing power and savings are not being eroded at the rapid pace they were at the height of the inflation crisis, there was some bad news buried within the data. Services inflation - a yardstick the Bank of England refers to when it sets interest rates - rose to 7.4%, while core inflation remained stubbornly high at 6.9%.

Alongside the wage growth data that was published on Tuesday (15 August), the figures mean the Bank of England is likely to be concerned about how embedded inflation is the UK economy. The result looks set to be another interest rates hike next month - a change that could spell more misery for mortgage payers.

But what is core inflation - and why is it so important to the Bank of England?

What is core inflation?

Core inflation records the rate of price hikes across the UK economy for all the goods and services we consume regularly, with the exception of energy, food, alcohol and tobacco.

The ONS says it is used to “assess the underlying inflationary pressures in the economy” whereas headline CPI can “be driven by temporary supply shocks, or other effects that do not have a lasting impact”. In other words, it strips out these categories because they are considered by economists to be too volatile, too seasonal and too integral to our daily lives to give an accurate reading on the cost of living.

They tend to rapidly rise and fall in a way that can disguise underlying inflationary or deflationary trends in the economy. For example, food prices can soar because of a bad harvest, but consumers are likely to pay the higher prices anyway because humans have to eat to survive. Taken on their own, therefore, these higher food prices do not mean there is a cost of living crisis.

So, what core inflation shows us is the rate of price rises for things we consume on a regular basis but which we could cut back on if our budgets are being squeezed. The cost of everything from cinema tickets to books and haircuts are included in the statistic.

What is the current core inflation rate?

As of July 2023, core inflation remained at 6.9% for a second consecutive month. It is only 0.2 percentage points off the record 7.1% posted in May - the highest level the measure has been at since March 1992).

Core inflation has now been above 6% for 11 out of the last 12 months. The latest figure is also above the headline CPI rate.

Why does core inflation matter?

What the core inflation figures show us is that the underlying cost of living crisis is not going away at the moment. Whether it’s due to wage increases maintaining high spending levels or staff shortages driving production prices up, inflation is not falling away to a more sustainable level (the Bank of England believes the ideal rate is 2%).

The figure also suggests that household budgets are likely to be struggling to stretch to things beyond life’s necessities, like food and energy. This is bad news for the economy as people have to be spending on a range of goods and services in order for UK GDP to grow. In turn, this is also bad news for Rishi Sunak. Two of his five pledges for 2023 (‘halving inflation’ and ‘growing the economy’) now appear to be contradictory - particularly after his Chancellor Jeremy Hunt said he would accept a recession (when GDP declines over two consecutive quarters) if it brought inflation down.

But the main reason why core inflation is so key is that the Bank of England closely follows the rate when it considers how to set interest rates. The latest inflation figures mean it is almost certain the UK’s central bank will opt to hike interest rates again in September - a move that will tighten the screw on homeowners with variable rate mortgages, like base rate trackers. Experts believe there are currently likely to be more people on these sorts of mortgages at the moment as people are waiting to see whether fixed rates will come down.

Any further increases to interest rates also makes a recession more likely. This is because it makes it harder for businesses to borrow to fuel their expansion or invest in their current operations - a knock-on impact of which can be a rise in unemployment. It all means core inflation can have a major, indirect impact on our personal finances.

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