With Consumer Prices Index (CPI) inflation now within touching distance of the Bank of England's target, the cost of living crisis seems to have entered its closing chapter.
The official rate of price rises, which is calculated monthly by the Office for National Statistics (ONS), remained static in August at 2.2%. A surge in the cost of flights was cancelled out by slowing price hikes for motor fuels and hospitality services. It leaves inflation is just 0.2 percentage points away from what the UK's central bank deems to be a healthy level.
While Threadneedle Street's top economists felt confident enough to cut interest rates for the first time since 2020 in August, inflation could bounce back to a slightly less sustainable level this autumn and winter. An increase in energy prices from 1 October, and another expected hike to the Ofgem price cap in January, mean the statistics could climb from November's data release onwards.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
It is not thought that the CPI will hit the heights it did at the peak of the cost of living crisis. In October 2022, its rate peaked at 11.1%. But, as we have seen over the last two years, any surprises in the data could keep interest rates higher for longer and make mortgage markets twitchy.
As well as calculating the CPI, the ONS also works out another measure of inflation - the Retail Prices Index (RPI). So, how do these measures differ - and what do they mean for your finances?
What is CPI inflation?
The CPI is the official measure for inflation. It also looks at the rate of change in prices for goods and services over a 12 month period. The current rate of the CPI stands at 2.2% for the 12 months to August 2024.
The reason why the CPI is the headline statistic for the UK is that it is an internationally recognised measure of the rate of price rises. As well as being the world's foremost inflation statistic, it also means our figures are directly comparable with those of other nations, even though our economy works in a uniquely different way.
To measure the CPI each month, the ONS looks at around 180,000 prices of 730 typical goods and services to see how prices have changed. This 'shopping basket' of items is reviewed each year to ensure the statistic keeps up with people's ever-evolving spending habits.
For example, the 2024 review reflected the move away from the Covid-19 pandemic as hand sanitiser was dropped from the basket. Air fryers and rice cakes were two new products that were included.
While this basket gives us an inflation figure, it is worth noting that inflation varies from household to household. For example, richer households have seen a lower inflation rate, generally, compared to poorer households given they are likely to spend a lower proportion of their monthly income on key goods and services, like food and energy. You can see what your personal inflation rate is using the ONS inflation calculator.
As well as showing you how much your bills and purchases have gone up or down in price over the past year, the CPI has a real-world impact on some day-to-day costs. For example, September's CPI plays a key roll in setting the state pension and other benefits, like Universal Credit. Here are other things the CPI sets and influences:
- Public sector pensions
- Statutory sick pay (SSP)
Another thing to note with the CPI is that the headline figure does not paint the entire picture of how prices are rising in the economy. Instead, it should be viewed as being more of a broad sweep.
Data within the data is more insightful if you're keen to understand how inflation is changing. For example, the Bank of England uses core inflation and services inflation when it decides how it will set interest rates.
Core inflation strips out categories that tend to see short, sharp fluctuations in prices, like food and energy. So, it can give an in-depth picture of how prevalent inflation actually is within the economy. Services inflation is similar and mostly covers the things we spend money on that fall outside of our core needs, like cinema tickets and hotel stays.
What is RPI inflation?
The RPI is another index used to measure rises and falls in the cost of goods and services over time. As of August, its annual rate fell back 0.1 percentage points to 3.5%.
It tends to track higher than the CPI because it includes costs associated with home ownership. RPI was the original official consumer price inflation measure. It was first implemented in 1956 and was the only measure of its kind for the health of the UK economy.
But in 1996, it was replaced by the CPI as the UK's headline rate and is now an unofficial statistic due to the way it's calculated not being up to modern standards. Although it is is no longer relevant as a measure of recent price hikes, it does allow us to see how inflation has changed since the 1950s.
Where it does still have relevance is when it comes to setting cost increases for some bills and services. For example, it is used by the government to set annual rail ticket price increases, and also sets particular levies, like road tax. Here are some of the other things RPI sets or influences:
- Tobacco duty
- Air passenger duty
- Alcohol duty
- Final salary pension payments
- Interest in student loans
- income from index-linked annuities
What is CPIH inflation?
The CPIH is another related measure the ONS uses - it is the Consumer Price Index including owner occupiers’ housing (OOH) costs. It remained sat at 3.1% last month.
It is similar to CPI, but includes the costs of owning, maintaining and living in a home. It means it also shares characteristics with the RPI. CPIH is the ONS's best measure of UK inflation given it captures more of the economy than the other two measures. However, given the UK housing system is different to that of any other nation, it is not internationally comparable.
What does high inflation mean?
High inflation means costs are rising at a rapid rate. Unless your money is keeping up (e.g. in a savings account or through wage increases) the value of your cash will erode over time.
So, if your savings are receiving interest of 5% and inflation is 6%, that pot of money will be losing spending power. Likewise, if your wages do not keep up with inflation, then you will effectively get poorer over time. Investors have also identified a high rate of price hikes as a major risk to their portfolios.
Most western economists agree that having a manageable rate of inflation is not a bad thing. The Bank of England has a remit to keep inflation at 2% - a level it believes allows for a good level of spending that will boost economic growth. The reason being that if prices are going up in the near-future, you may as well complete a purchase today.
It also means your wages are more likely to stay in touch with the rate at which spending power is being eroded. The UK central bank tries to keep inflation close to its target by moving or freezing interest rates.
At present, wages are outpacing inflation. There are also many savings accounts that are beating inflation, although you may need to act fast to get the best deal given the Bank of England could cut interest rates further before the end of the year.
What impact does low inflation have?
Low inflation means prices are rising at a slow rate. Meanwhile, deflation means prices are falling. Both scenarios may sound like good news after two-and-a-half years of soaring price hikes.
Indeed, they can lead to short-term boosts in economic activity and tax receipts - something seen earlier this summer when retailers slashed the prices of TVs ahead of Euro 2024 and the Paris Olympics. But, if sustained for a long period, low inflation and deflation can indicate a weaker economy, with deflation likely to be particularly bad for GDP growth.
If inflation comes in below 2%, most economists believe that spending will generally decrease. With wages likely to outpace the rate of price rises, consumers are more likely to be incentivised to hold onto their disposable incomes, which means less money will move around the economy and the government's tax revenues will fall.
In a deflation scenario, these effects are only likely to be turbo-charged. After all, why spend your money now if what you're buying could be cheaper next week? But the chances of economy-wide price hikes turning into widespread price drops seems extremely low at the present time.
