How inflation is calculated
- Shunil Roy-Chaudhuri
- 22 September 2022
- 5 mins reading time
Consumer price inflation is the rate at which the prices of goods and services bought by consumers rise or fall. It is estimated by using consumer prices indices. One way to understand a prices index is to imagine a very large shopping basket containing all the goods and services bought by consumers. The prices index estimates changes to the total cost of this basket, enabling us to calculate the inflation rate.
The Consumer Prices Index (CPI), which the Office for National Statistics (ONS) calculates every month, measures a wide range of prices. However, the Consumer Prices Index including owner occupiers’ housing costs (CPIH) is the more comprehensive measure of the inflation rate. It extends CPI inflation to include a measure of the costs for someone owning, maintaining and living in their own home, along with Council Tax. But it may be of less relevance to people living in rental accommodation.
This article focuses on CPI inflation, as it is the best known inflation index. Annual CPI inflation stood at 9.9% in August 2022. CPI is calculated by recording the prices of a typical selection of consumer products from month to month, using a large sample of shops and other outlets across the UK (including the provision of goods and services via the internet).
CPI inflation could include consumer items such as bread, ready-made meals, a cinema seat, a pint at the local pub, and a bicycle. The content of the CPI basket is fixed for a period of 12 months and, as the prices of individual products vary, so does the total cost of the basket. CPI, as a measure of that total cost, gauges price changes (or inflation).
The quantities, or ‘weights’, of the various items in the CPI basket are chosen to reflect their importance in the typical household budget. In practice, we each purchase a variety of goods and services in differing quantities, and each of these items has its own price movements. Even so, it is still helpful to have generalised price measures. These may not strictly apply to any one individual or family, but they still give us a useful yardstick of the impact of CPI inflation on our own pocket.
Care is taken to ensure the CPI shopping basket is up to date and representative of people’s spending patterns: the places and shops we go to, the goods and services we buy and the amounts we spend on them. And the inflation index simply indicates what we would need to spend in order to purchase the same things we bought in an earlier period.
It is unnecessary for the Consumer Prices Index of inflation to monitor the price of every product sold in every shop. Prices of similar items can reasonably be assumed to move in tandem, in line with market forces. It is therefore sufficient to compile CPI inflation using prices of a large and varied sample of products in selected locations. The goods and services for which prices are recorded for CPI are called ‘representative items’.
The Consumer Prices Index is calculated from the price movements of around 700 specifically chosen representative items. There are, for example, several items in the CPI basket covering purchases of bread, such as a large white sliced loaf and a large wholemeal loaf. These are combined to estimate the overall change in bread prices.
We spend more on some things than others. So we would expect, for example, a 10% increase in the price of petrol to have a much bigger impact on CPI inflation than a similar rise in the price of tea. For this reason, the components of the CPI inflation index are ‘weighted’. This ensures CPI reflects the importance of the various items in the average shopping basket, and the amounts we spend in different regions of the country and in different types of shops. Broadly speaking, items that have high impacts on our pockets are given a greater weighting in the Consumer Prices Index than those that have low impacts.
In come meat-free sausages, out go doughnuts
The basket of goods and services in the Consumer Prices Index is reviewed each year. This helps to ensure CPI inflation calculations continue to accurately reflect UK shopping and purchasing patterns. Some changes to the CPI basket are made due to changing markets, fashions and new products. So smartphones were added in 2011 and tablet computers in 2012.
In 2022, 19 items have been added to the CPIH basket, while 15 items have been removed. Additions to the baskets for 2022 include meat-free sausages, canned pulses, sports bras, pet collars and antibacterial surface wipes. Removals from the baskets include doughnuts, men’s suits and coal.
The index weights are also changed each year, in line with alterations to our spending habits. For example, in recent years, people have spent more on electrical goods, travel and leisure, while the proportion they spend on essentials has fallen.
Typical household spending on some individual goods and services, such as petrol and electricity supply, is so large that they merit inclusion in the CPI baskets in their own right. More commonly, a sample of specific goods and services must be selected that gives a reliable measure of price movements for a broader range of similar items.
Several factors need to be considered when choosing representative items for the Consumer Prices Index. For example, it makes sense to choose more items in product groups where spending is high. Moreover, if price movements of all possible items in the group are very similar, it is sufficient to collect prices for only a few.
After price data have been checked and processed, the resulting price indicators are combined using the weights for the current year to produce an overall average price change. The annual rate of inflation is simply the percentage change in the latest Consumer Prices Index compared with the value recorded 12 months previously.
This article is derived from the following two ONS sources: Consumer price indices, a brief guide: 2017, 3 November 2017; and Consumer price inflation basket of goods and services: 2022, 14 March 2022.
Any views expressed are our in-house views as at the time of publishing.
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