What are inflation and deflation?

CPI, RPI and core inflation explained

Prices are changing all the time, usually upwards, and the rate these changes are measured is generally called inflation. However there are a few different options here, so we’ve broken down what they all mean, and why they matter.

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What is inflation?

Inflation is a measurement that helps us track the price increase of goods and services over time. 

It compares the cost of things today with how much they cost a year ago. And the average increase in prices is what we call the inflation rate. 

Let’s take a loaf of bread as an example. If it costs £1 to buy a loaf today and next year it costs £1.10, the annual inflation for that loaf of bread is 10%. 

And falling inflation doesn’t mean prices will go down. If a rate moves from 5% to 4% month on month prices are still increasing, they’re just doing so at a slightly slower rate.

What is deflation?

Deflation works the opposite way and tracks the rate that prices decrease for goods and services over time. 

So looking at that loaf of bread again. If it costs £1 to buy a loaf today but that falls to 90p next year, then the deflation rate would be -10%.

How is UK inflation measured?

The Office for National Statistics (ONS) is in charge of measuring inflation in the UK and publishes figures each month to show how prices have changed. 

There are three common measures of inflation; Consumer Prices Index (CPI), Consumer Prices Index with Housing (CPIH) and the Retail Price Index (RPI). 

This can get a little confusing at first with all of the different figures, but the breakdown below shows how each one works and how relevant it is to you. 

CPI inflation

The Consumer Price Index (CPI) is the UK’s official measure of inflation and the rate you’re likely to see make headlines. 

For CPI, the ONS tracks around 180,000 prices of 700 hundred everyday items in an imaginary shopping basket (called the basket of goods) to work out the inflation rate. 

These everyday items and services fall into one of the following categories: 

• Food & non-alcoholic beverages
• Alcohol & tobacco
• Clothing & footwear
• Housing & household services
• Furniture & household goods
• Health
• Transport
• Communication
• Recreation & culture
• Education
• Restaurants & hotels
• Miscellaneous goods & services

The basket of goods gets reviewed each year to make sure that it gives an accurate picture of how price rises relate to our spending habits and patterns.

This means that products and services might get added to the basket each month, while others are taken out.  

What is core inflation?

Another measurement for inflation you may have come across is “core inflation.” Core inflation tracks the same goods and services as CPI but doesn’t include food, energy, alcohol and tobacco. 

These are taken out as they’re generally seen as the most volatile, so core inflation should give us a better understanding of how prices are changing outside of the everyday essentials.

CPIH Inflation

CPIH is a measure of UK inflation that takes into account housing costs, as well as everyday goods and services. 

It uses the same basket of goods as CPI but also includes prices for things like the cost of owning, renting or maintaining your home. It also takes into account expenses like council tax.  

CPIH is the newest measure of inflation and was introduced in 2013 to plug some of the gaps left by CPI (mainly the lack of tracking of housing costs.) 

RPI inflation

RPI used to be the main measure of inflation in the UK until it was replaced by CPI in 2011. 

It tracks the same basket of goods currently used for CPI but also includes things like estate agent fees, buildings insurance, TV licence and mortgage interest payments (which aren’t included anymore!) And, it tends to be higher than the CPI and CPIH measure of inflation. 

Although RPI isn’t the main inflation figure anymore, it’s still used to set the price of things like interest on student loan repayments and rail fare increases we get each year – though there is the flexibility from the government to pick a lower rate if RPI is significantly high.

RPI also plays a big role in the level of retirement income people get from final salary pensions and annuities. 

Do we really need RPI?

So you might be wondering why we still use RPI if it’s technically been replaced. Well, there’s an ongoing debate about its purpose and relevance. 

On one hand, final salary pension schemes and annuities may see less of an income boost if RPI was scrapped altogether. 

However, the government’s use of RPI compared to CPI, in particular, has also come under fire. 

Usually, the government links its own spending – which includes things like the state pension, statutory sick pay and benefits – to the CPI rate of inflation, which is lower. 

However, it uses RPI (which is higher) when it comes to the costs we pay such as train tickets, car tax and student loan interest to name a few. 

At this stage, it remains to be seen what will happen with RPI and whether it is replaced completely by one of the other inflation measures. 

How does inflation affect me?

Inflation shows how much the cost of living is rising and gives you an idea of your spending power. So, the higher the rate of inflation, the more expensive everyday expenses tend to be. 

With the current cost of living crisis, we’ve all seen how sharply prices have risen over recent years. From eye-watering grocery bills to the cost of heating and powering our homes, prices have risen across the board. 

High inflation has also caused significant increases to the interest base rate by the BoE. That’s because the BoE raises interest rates in an attempt to bring down inflation to its 2% target. And changes to interest rates can impact both borrowing (especially mortgage) and savings.

Inflation also increases the risk of your money losing value in real terms. One area is wages. If they don’t increase in line with inflation you’ll need to use a higher proportion of your income to buy the same goods and services.

Similarly, your savings could lose value as well because, if your money is earning less interest than the rate of inflation – you won’t be able to buy as much with it.