What is the CPI (Consumer Price Index)?

Jun 20, 2023

4 min read

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The CPI is the Consumer Price Index. It’s one of the key ways we measure domestic inflation in the UK. (Other nations such as the USA have their own domestic CPI.)

The UK government actively uses the CPI as their basis for working out inflation targets, as well as using it to help inform their policies on things like state pensions and benefits.

How is the CPI calculated?

The CPI measures the average change in how much goods or services cost, on a month-to-month basis.

Here’s how the process works:

Mid-month, the CPI will collect information from thousands of businesses around the UK on the current price of their goods and services. (Overall, the CPI looks at 700 different goods and services.)
The CPI then calculates the average change of these goods and services compared to the month’s figures.

They then release the new figures in a monthly announcement, showing how the average pricing has changed over the past month.

(The CPI will also usually release quarterly and yearly comparisons, too.)

Which 700 goods and services are measured changes over time to match the general buying habits of the British public.

An example of this would be in March 2023, when electric bikes were added to the list of included goods for the first time.

Why is the CPI important?

Inflation is a key economic factor for policy makers in the government and in central banks.

Indirectly, then, the CPI can have an impact on things like your pension and any benefits you might want to claim.

What happens when the CPI increases?

If the CPI increases, interest rate rises can follow. Higher interest rate rises are a fairly standard economic policy move to combat inflation.

Here’s a quick example that should explain why:

Let’s say someone borrows £5,000 from you, with a promise to repay with 10% interest over the next year.

Let’s say, though, that over the next 12 months, inflation rises by 10%.

This would mean that although you’ve technically made 10% interest, in terms of what you can actually buy with it, that £5,500 isn’t actually worth any more than the £5,000 you lent the year before.

Essentially, your ‘interest’ is worthless in real terms.

So, you lobby the government to increase interest rates on the deal to 20%.

This means that you will now be repaid £6,000. This means that you have gained £500 in spending power despite the increase in inflation.

Hopefully that makes it clear why banks, credit institutions and the like tend to raise interest rates on variable interest products like credit cards and mortgages.

It’s so they don’t lose money in real terms when inflation is high.

The problem with this policy is that increasing interest rates makes it likely more people will default on their debt if it suddenly increases.

So, balancing interest rates and inflation is a constant balancing act, which the CPI can assist policymakers with.

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