Throughout the year, you hear many different economic indicators mentioned on the news. Base rates to inflation, CPI to RPI, CPIH, budget deficits, savings rates and much more. As consumers, the most important figures are base rates, inflation and savings rates. These will ultimately determine your relative spending power as we advance.
What is inflation?
In simple terms, inflation is the “rate of increase in prices over a given period”. This all looks pretty straightforward. However, this is where it starts to get very complicated!
Consumer Price Index (CPI)
The CPI is used to reference inflation in the UK, indicating the change in the value of a typical basket of goods and services. This figure takes into account the changing cost of a range of items, including:
- Bread
- Ready-made meals
- Cinema tickets
- Holidays
- A pint at your local pub
This is just a small example of the figures taken into account, which are adjusted to reflect lifestyle changes over the years.
Consumer Price Index including Housing (CPIH)
The CPIH figure is becoming more popular. This is simply an extension of the CPI to include the cost of running and maintaining Owner Occupied Homes (OOH). This figure takes in what is referred to as “rental equivalence”, which does not refer to mortgage payments but the element of rent you would pay for a comparable property.
Retail Price Index (RPI)
For many years the RPI was the leading indicator of inflation, taking into account a basket of everyday goods acquired by the UK public. At first glance, this sounds awfully like the CPI, but there are some subtle yet significant differences. For example, the RPI takes into account additional expenses such as mortgages, council tax, house depreciation, buildings insurance, ground rent, estate agents/conveyancing fees and more.
Current inflation rates
As of August 2021, the annual increase in each of the above-inflation indicators was as follows:
- CPI +3.2%
- CPIH +3.0%
- RPI +4.8%
The Bank of England currently has a target rate of 2% for the CPI, their preferred measure of inflation, which is much lower than the RPI. Many people argue that the selected choice of “inflation indicator” does not represent changes in the actual cost of living. However, the government believes that the RPI is too volatile and the method of calculation is not recgnised on the international stage. As a result, the RPI will be phased out and removed from the list of UK economic indicators in 2030.
The following chart will give you an idea of how the rates have fluctuated in recent times:
Source: https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/august2021
Source: https://commonslibrary.parliament.uk/, used under Open Parliament Licence v3.0.
Why delay the removal of the RPI?
Interestingly, the RPI is still used as a means of increasing an array of payments such as:
- Final salary pension schemes
- Income from index-linked annuities
- Income from some index-linked government bonds
- Train tickets
- Air passenger duty
- Car tax
- Tobacco duty
- Alcohol duty
- Interest on student loans
As you can see, selective use of the RPI increases the government tax take by a significant amount compared to the CPI. Also, the removal of RPI when calculating pension, bond and annuity income, and switch to the lower CPI, would not be a vote winner.
Why is the CPI so beneficial to the government?
Before we answer this question, it is worth reminding ourselves of the items which are linked to CPI as opposed to RPI:
- State pension
- Public-sector pensions
- Lifetime allowance for pensions
- Personal Independence Payments (PIP)
- Attendance allowance
- Jobseekers allowance
- Universal credit
- Housing benefit
- Income support
- Statutory maternity/paternity pay
- Statutory sick pay
It is fair to say that the government has saved billions of pounds by reducing the annual increase in the above items simply by using the CPI rate. For example, when government bond payments, which increase in line with inflation, switch from RPI to CPI in 2030, this is projected to save the UK government £2 billion a year.
Inflation, base rates and relative spending power
As consumers, the pound in our pocket will be worth a pound tomorrow, in five years, ten years, and so on. However, if we look at this in terms of relative spending power, the situation is very different. In this instance, we will use inflation (CPI) and base rates. As we will cover later, the problem is much worse when you bear in mind that bank savings rates are currently circa 0%.
What are base rates?
The base rate, sometimes confused with bank savings rates, is the interest charged by the Bank of England when lending money to commercial banks. The savings rate is the interest paid to bank customers by commercial banks. At this moment in time, UK base rates currently stand at 0.1%, with savings rates circa 0%.
As base rates effectively dictate the rate banks will charge for finance and pay those with savings, it has proven very useful since the 2008/9 US mortgage crisis. Cheap finance has helped to support the UK economy but at what cost?
Relative spending power
The following graph perfectly illustrates the historical and the current relationship between base rates and the CPI. Aside from a period in the mid-70s and the aftermath of the 2008/9 US mortgage crisis, interest rates have predominantly been higher than inflation.
This means that interest paid on savings tends to be higher than inflation, creating a net increase in relative spending power. The best way to illustrate relative spending power is the following hypothetical example:
Capital: £100
Annual savings interest rate: 5%
Annual inflation: 3%
Your £100 in capital would need to be worth £103 in 12 months to keep pace with inflation. This means that you would be able to buy the same “basket of goods and services” represented by the CPI. In this example, savings interest is 5% which equates to £5 per annum. So when you subtract the £3 increase in the cost of living from the £5 increase in your savings, you have a net increase of £2 per annum in your relative spending power.
It is fair to say we are in uncharted economic waters due to the 2008/9 US mortgage crisis and the global pandemic. This is reflected in the following current figures:
Capital: £100
Annual savings interest rate: 0%
Annual inflation (CPI): 3.2%
Taking one year in isolation, with the CPI figure running at 3.2% per annum, buying the same basket of goods which cost you £100 today would cost you £103.20 in 12 months. Maintaining your relative spending power would require a savings interest rate of 3.2% per annum. Unfortunately, while base rates are 0.1%, commercial bank savings rates paid to customers are circa 0%. So in effect, to secure the same spending power in 12 months, you have a £3.20 shortfall. Any alarm bells ringing?
If we assume that you have capital of £10,000, inflation remains at 3.2% over the next five years, with base rates unmoved and savings rates still circa 0%, the situation is more profound:
| Year | Capital | CPI | Capital x Inflation | Shortfall |
| 1 | £10,000 | 3.2% | £10320 | £320 |
| 2 | £10,000 | 3.2% | £10650 | £650 |
| 3 | £10,000 | 3.2% | £10991 | £991 |
| 4 | £10,000 | 3.2% | £11342 | £1342 |
| 5 | £10,000 | 3.2% | £11705 | £1705 |
The above figures perfectly illustrate not only the reduced relative spending power when inflation is higher than savings rates but the compound impact of inflation on inflation.
As you can see, the impact of annual inflation of 3.2% and 0% savings rates equates to a shortfall after five years of £1705. This is the additional amount of capital you would require to acquire the same goods which cost £10,000 just five years ago. If you used the historic RPI figure, assuming it remained static at 4.8% during the five years, this would create a relative spending power shortfall of £2641 per annum. So it’s not surprising that the Bank of England would prefer to use the CPI!
Considering that UK base rates have been around historic lows for the last ten years, any element of positive inflation has eroded the relative spending power of those with savings. In effect, those who have “saved for a rainy day” are the victim of the recent and ongoing economic turmoil.
The creeping impact of inflation
In order to maintain relative spending power, your income will need to increase by at least inflation on an annual basis. Again, it is crucial to reiterate that we live in relatively unique times regarding base rates, inflation, and savings rates. However, over the last ten years, those with savings have seen their relative spending power slashed.
The Bank of England does not expect base rates to rise until 2022 at the earliest and forecasts CPI inflation to peak at 4%. Consequently, those with savings, predominantly pensioners who have saved for security and peace of mind, will continue to see their relative spending power eroded over time. The most cautious amongst us are the ones who have suffered. In reality, there is no light at the end of the tunnel as yet.