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

The UK’s inflation rate climbed unexpectedly in February to 10.4%, the latest Office for National Statistics (ONS) Consumer Prices Index (CPI) has shown.

Experts still believe the rate of price increases will go down over the course of 2023, with the Office for Budget Responsibility predicting it will drop to 2.9% by the end of 2023 - although this will still mean prices are going up. But the latest hike could mean less of a decline is on the cards, which would be bad news for Rishi Sunak, who has staked his reputation on a big fall in inflation this year.

It is also bad news for the cost of living crisis more broadly, particularly given food price rises have become steeper in the latest ONS statistics. While the CPI remains lower than its record 41-year high of 11.1% in October 2022, further inflationary squeezes are set to hit consumers in April when council tax, water bills and mobile deals are due to get more expensive.

Alongside inflation, other issues contributing to the cost of living crisis include high interest rates and the UK’s poor economic outlook. A higher Bank of England base rate means mortgage costs tend to be higher, while a reversal in economic growth - even if it isn’t counted as a technical recession - can make wage increases are harder to come by

But how are inflation statistics calculated - and what exactly does high inflation mean for you?

What is inflation?

Inflation is an economics term for a sustained increase in prices that simultaneously sees purchasing power decrease. These price hikes are driven by many different factors, like the price of oil, supply chain disruption, Brexit-related labour shortages or the scarcity of a particular product - i.e. whatever affects the cost of getting products from where they are produced to the consumer, as well as the quantity of what is produced.

For example, the cost of vegetables rose 18% in February, with the ONS saying it could be as a result of the shortages of salad ingredients in supermarkets. These shortages were caused by a combination of factors, including bad weather in Spain and Morocco, high energy prices and supermarket practices.

Food prices have been hit more generally by the Russia-Ukraine war as both countries are key suppliers of the grains and oilseeds used to feed cows. Russia, in particular, is a key source of the fertiliser used to grow the grass that feeds herds, the fuel that keeps tractors moving and the energy that powers milk processing facilities. Given the conflict has either tightened or completely halted the supply of these commodities from both countries, global markets have seen price spikes.

Sharp rises in inflation, like the one seen for food items, can severely impact the cost of living and see consumers opt to reduce their spending - especially on luxury goods and services. Overall, this is bad news for the economy.

But gradual inflation is seen by some 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 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. 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.

Research has also indicated that the cost of living has risen much more for those on the lowest incomes. Research by progressive think tank the Resolution Foundation has found the poorest tenth of the UK population saw price rises of 12% in January compared to 9% for the country’s wealthiest tenth.

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.

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.

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 hit a rate of 13.8% in February 2023.

What does the current CPI mean?

The CPI rate was 10.4% in February 2023. What this means in practice is that the average price of goods and services cost 10.4% more than in January 2022. In real terms, an item that cost £1 last year now costs an average of £1.10 (when we round the figure down).

Ultimately, it means the purchasing power of the pounds in your pocket has diminished significantly since last year. This level of inflation builds on what was already a high rate of 6.2% that was recorded in February 2022 and means it remains near the 41-year high recorded in October of 11.1%.

Liz Truss’s scaled back Energy Price Guarantee has meant energy bills will not contribute to inflation to the same extent they would have if the Ofgem Price Cap had gone ahead as planned in October 2022. But hikes to household bills, like council tax and water, from April could see it rise again.

At the same time, the UK is expected to see its economy decline over the course of 2023 - an issue that could mean unemployment increases and wages continue to rise below the rate of inflation. It all means our budgets are going to struggle to keep up with inflation, even if it decelerates, so don’t expect the cost of living to disappear from the agenda anytime soon.