The annual Consumer Price Index (CPI) is one of the most prominent economic indicators that reflect the state of inflation in any country. In the United Kingdom, people use this index periodically to measure changes in the prices of goods and services consumed by British households. This index provides an accurate picture of changes in the costs of daily living. Government policies and the British Central Bank are greatly influenced by this index in making economic decisions.
What is the annual Consumer Price Index?
The Consumer Price Index is a measure of the change in the prices of a group of goods and services that are used on a daily basis. This index includes the prices of food, clothing, transportation, education, health care, and other services consumed by households in the United Kingdom. This index changes over time according to economic changes such as economic growth or recession.
The Consumer Price Index is calculated on an annual or monthly basis, comparing the price of a group of goods and services in a specific period with the same period last year.
The Importance of the Consumer Price Index in the British Economy
The Consumer Price Index is a major factor in determining inflation in the United Kingdom. When the index rises, it means that prices have generally risen, which increases the cost of living for households. When the index falls, it indicates that prices have fallen, which helps reduce pressure on households.
The British central bank, the Bank of England, relies heavily on this index in making monetary policy decisions. If inflation is above target, the central bank may raise interest rates to contain inflation. If inflation is too low, the bank may lower interest rates to stimulate economic growth.
Rising inflation in the UK services sector is prompting the Bank of England to gradually cut interest rates (for now)
Services inflation is expected to rise to around 5% in the winter, while the headline CPI could be close to 3% in January, which reduces the chances of a December rate cut, but in the spring we think there is a good chance the Bank of England will accelerate its easing cycle.
UK services inflation was slightly higher than economists had expected in October. But at 5%, it is only slightly higher than in September and in line with the BoE’s forecast. Interestingly, when we dig into the details, much of the recent steadiness lies in categories that the Bank seems to regard as less important and less indicative of “persistent” inflation.
This is true of things like rents, which were particularly strong on a monthly basis in October, although this could be linked to social rents, which are only updated quarterly. Airfares and all-inclusive holidays, which are notoriously volatile categories, also explain some of the recent rise in services inflation.
The BoE likes to leave these out and focus on so-called “core services” inflation. There is no single definition of inflation, but our preferred measure in the chart below, which mirrors the Bank of England’s previous work, has fallen from 4.8% to 4.5%. This is a different story to what the headline services figures tell us.
Comparing UK inflation to other countries
Inflation in the UK is compared to other countries to determine whether the UK is experiencing higher or lower inflation than other countries. In recent times, many developed countries have seen inflation rates rise.
Factors that affect the CPI
Many factors affect the annual changes in the Consumer Price Index. The most prominent of these factors are:
- Changes in energy prices: Oil and natural gas are commodities that greatly affect inflation. When energy prices rise, transportation and production costs rise, leading to an increase in the prices of many commodities.
- Changes in food prices: Food prices are one of the largest components of the Consumer Price Index. Any significant changes in food prices directly affect this index.
- International inflation: Sometimes, prices in the United Kingdom can be affected by the global economic situation. For example, if global inflation occurs as a result of increased demand or decreased supply of some commodities, the Consumer Price Index in the United Kingdom may rise.
- Changes in government policies: Government decisions play a role in determining the cost of living. For example, increasing value-added tax or imposing additional fees can lead to an increase in prices.
- Labor market: The state of the labor market greatly affects inflation. When the unemployment rate rises, demand for goods and services may fall, leading to lower prices. Conversely, when a large number of jobs are available, demand for goods and services increases, leading to higher prices.
How is the CPI calculated?
The CPI calculates data on the prices of a range of goods and services used by UK households. Experts weight each item based on its importance in the household spending basket. For example, food and transport are heavier items in the basket than furniture or entertainment.
Inflation in ‘essential services’ falls faster than the headline figure
Will this make any difference to the Bank of England’s December decision? We doubt it, but remember we still have another reading before that.
The government’s role in tackling inflation
The UK government is seeking to reduce the impact of inflation on households through a range of policies. These include:
- Increased support for households: The government is providing financial support to low-income households to help them meet the cost of living.
- Monetary policy: The Bank of England is adjusting interest rates to control inflation.
- Fiscal policy: Fiscal policy helps support investment and stimulate economic growth.
All of this means that the Bank is likely to continue its “gradual” rate cut path for now, with analysts widely understanding it to mean one cut per quarter. We expect a pause at next month’s meeting.
But this nuance of core services inflation is crucial. We believe the downward trend will continue, although perhaps not for the next couple of months. Assuming this continues, we think this means that the Bank of England may become more aggressive in cutting interest rates over time. The timing is not easy, but we think that a cut in February and then another in March (and then two more cuts after that) remains a reasonable base case.
