Rising inflation eats away at the value of our income, savings, capital, and purchasing power. When prices rise in one part of the economy, it can have a knock-on effect. For example, when the cost of fuel goes up it costs more to transport goods. When this happens the price of food and raw materials increases. When major companies face rising costs and lower profits their share value can drop, causing the value of our investments to go down. In short, inflation can be a vicious cycle.
While we can easily feel the effects of inflation on our personal finances, it’s more complex to measure it objectively. In the UK, we use two main methods of measuring inflation: RPI and CPI. These indices and their variants not only attempt to calculate inflation but they also have implications for how much income such as pensions and benefits rise, as well as how much items such as train tickets and taxes go up. In this article, we look at what RPI, CPI, and other common inflation indices are, how they are calculated, and the effect they can have on your personal finances.
- What is RPI?
- What is CPI?
- What is CPIH?
- What exactly is in the RPI and CPI ‘shopping baskets’?
- Why do we have different measures of inflation?
- What does RPI affect?
- What does CPI affect?
- Isn’t it unfair to use different measures of inflation?
- How can you work out your personal inflation rate?
- How can I inflation-proof my finances?
RPI stands for the ‘Retail Price Index’. It was first introduced as an official measure of inflation by the UK government in 1956. Before then, the government used two different measures of inflation. The first, the Cost of Living Index, was in use between 1914 and 1947. The second, The Interim Index of Retail Prices, was used between 1947 and 1956. For simplicity, all three of these are commonly referred to as RPI.
Today’s RPI is calculated each month by the Office of National Statistics (ONS). It is done by pricing up a representative basket of current goods and services and then dividing the figure by the number of items (resulting in an average, or arithmetic mean). By comparing one month’s RPI to another, it’s then possible to calculate increases or decreases in inflation.
The goods and services in the RPI basket are changed annually, but they are very broad ranging. For example, the 2022 RPI includes hundreds of food items, as well as services that range from mobile phone contracts and playgroup fees to car servicing and online gaming subscriptions.
RPI is also heavily influenced by housing costs. This is because it includes items such as private and social rents, along with mortgage interest payments. This is one reason why RPI tends to overstate inflation when compared to other measures such as CPI (see below). This is particularly true when house prices and interest rates increase rapidly.
Although RPI is still compiled monthly by the ONS, it is no longer classified as a ‘national statistic’. In a 2018 press release, the ONS said: “Our position on the RPI is clear: we do not think it is a good measure of inflation and discourage its use.”
That said, RPI is still used for a wide range of purposes. We’ll cover these a little later in this article.
CPI is the ‘Consumer Price Index’. It was first introduced in 1996 as the ‘Harmonised Index of Consumer Prices’ (HICP). HICPs were calculated by countries across the Eurozone, allowing the European Central Bank (ECB) to compare inflation between member states. This meant the ECB could assess whether countries that planned to switch to the Euro currency could pass certain inflation convergence criteria.
In December 2003, the name of HICP in the UK was changed to the Consumer Price Index (CPI). In that year, the then Chancellor of the Exchequer announced that the country’s inflation target would be based on CPI, replacing RPIX (RPI excluding mortgage interest payments).
Like RPI, the CPI is calculated using a basket of different goods and services. However, unlike RPI, it does not take housing costs into account. CPI is also calculated using a geometric mean rather than an arithmetic mean. The reasons for this are rooted in the original HICP, but this type of calculation tends to result in lower inflation increases.
CPIH is the Consumer Prices Index including owner occupiers’ housing costs. The Office of National Statistics argues that CPIH is the ‘most comprehensive measure of inflation’. Housing costs are not calculated using mortgage payments, but something called ‘rental equivalence’. This is how much rent a house owner would pay for an equivalent property. CPIH will be used more commonly in the future.
The ‘shopping baskets’ of goods and services used to calculate RPI and CPI change each year to better reflect consumer spending. For example, in 2022 items like meat-free sausages, antibacterial surface wipes, and recreational climbing sessions were added to both indices. At the same time, items that were removed included laminate flooring, reference books (such as atlases and dictionaries), and coal.
You can download the most recent RPI and CPI shopping baskets as an Excel spreadsheet via the ONS website.
We’ve seen that there are historical reasons why we have different measures of inflation. While the RPI was the UK’s official measure of inflation from 1956, it began to be supplanted by the CPI (and CPIH) from the early 2000s.
However, to add to the confusion, different measures of inflation are still used for different purposes by government and companies. Some critics believe this is ‘inflation shopping’. For example, many items that provide the government with income (such as tobacco and alcohol duty) are linked to RPI, which consistently calculates a higher rate of inflation and thus extra income. On the other hand, increases in government expenditure (such as that on state pensions and benefits) are linked to the lower CPI index, resulting in a lower rate of increased spending.
RPI is used to set ‘in line with inflation’ increases for most excise duty rates and some other forms of government income. These include:
- Tobacco duty
- Alcohol duty
- Air passenger duty
- Vehicle excise duty (sometimes known as ‘road tax’ or ‘car tax’)
- Council Tax
In addition, RPI is also used to set increases in the cost of:
- Train tickets
- Mobile phone airtime tariffs
- Income from index-linked annuities
- Income from (some) index-linked bonds
- Interest on Student Loans
- Final salary pension payments
CPI is frequently used by the government to set income tax allowances and thresholds, as well as to set increases in benefits and pensions. These include:
- State pensions
- Public sector pensions
- Lifetime allowance for pensions
- Personal Independence Payments (PIPs) / Attendance Allowance
- Universal Credit / Jobseeker’s Allowance / Income Support
- Housing Benefit
- Statutory Sick Pay
Many people have pointed out that it’s unfair that consumers end up being hit with higher RPI increases for goods and services, while many forms of income rise only by the typically lower CPI figure. However, in 2020 the government announced that – from 2030 – RPI will be replaced by CPIH. Increases in CPIH inflation are consistently lower than those calculated using RPI.
Once CPIH replaces RPI, it will benefit people such as commuters (annual ticket price increases should be lower) and graduates (annual Student Loan increases should be smaller). However, income from final salary pensions will not increase as much as before, nor will income from index-linked bonds and annuities.
Some people are more affected by inflation than others. For example, someone who has paid off their home loan won’t be affected by increases in mortgage rates. Similarly, if the price of food increases, it will affect families to a greater extent than adults who live alone.
While calculating your personal inflation rate from scratch would be complex, the ONS provides an inflation calculator that shows how cost-of-living increases have affected you in the last year. You simply need to answer a number of questions to find out how your monthly spend has increased and discover which price increases are making the biggest impact on your finances. You can access the inflation calculator here.
When inflation is high, everyone is affected. While it may not be possible to inflation-proof your personal finances, there are steps you can take to mitigate the effect of price rises. These include:
- Review your savings. Interest rates have been historically low since the 2008 financial crisis, meaning that cash savings accounts offer very little return on your money. That said, we are currently seeing a significant increase in savings rates following the Bank of England’s increase to the base rate. It’s now more than important than ever to review your savings account. You may want to consider using tax breaks such as ISAs and pension contributions. You can put £20,000 tax-free into an ISA each year and, for every £80 a basic-rate taxpayer puts into a personal pension HMRC will contribute another £20.
- Consider stock market investments. If you are looking to the long-term, it’s worth considering investments in stocks and shares. While global stock markets can be turbulent in the short-term, investments offer the potential for better returns over longer periods.
- Evaluate your spending. The less you spend, the less your purchases are affected by inflation. Review your budget regularly and see where you can make reductions.
Read our article for more information on how to reduce the impact of inflation on your personal finances. You may also want to consider the benefit of using an independent financial adviser, who will be able to put together a financial plan that considers inflationary pressures when helping you reach your financial goals. For further information, contact us on 01603 967967.
The value of investments and any income from them can go down as well as up and you might not get back the original amount invested. The past is not a guide to the future.
The value of tax benefits depends on your individual circumstances. Tax laws can change.