With the Office for National Statistics (ONS) announcing that inflation, measured by the Consumer Price Index (CPI), rose by 3% in the 12 months to January 2025, now is a good time to take a closer look at what the CPI actually is, how it’s calculated, and why it matters.

What is CPI and How Does it Work?

The CPI is a key measure of inflation, tracking how the prices of everyday goods and services change over time. It is compiled by the ONS and is a crucial tool for both the government and the Bank of England when setting economic policies, including interest rates.

How CPI is Calculated

The CPI isn’t just a random figure – it’s built on a structured approach that takes into account what people in the UK are actually spending their money on.

1. The “Basket of Goods and Services”

To measure price changes, the ONS tracks the cost of a representative shopping basket filled with commonly purchased items. This basket includes:

• Food and drink
• Clothing and footwear
• Transport costs (including fuel and public transport)
• Housing costs (excluding mortgage interest payments)
• Recreation and entertainment

Since shopping habits change, the basket is updated every year to reflect new trends. For example, streaming subscriptions have replaced DVDs, and plant-based food items have been added as they become more popular.

2. Collecting Price Data

Each month, thousands of price points are collected from retailers, supermarkets, online stores, and service providers across the UK. The goal is to ensure consistency by tracking identical or comparable products over time.

3. Weighting Different Categories

Not all goods in the basket contribute equally to the overall CPI figure. The ONS assigns weightings based on how much the average household spends on each category.

For example:

• Energy bills have a greater impact on the CPI than cinema tickets because people spend more on heating and electricity than on going to the movies.
• Food and fuel prices are closely monitored as they have a big impact on the cost of living.

4. Calculating the Index

The ONS then compares the total cost of the basket in the current month to a chosen base year (which is set to 100). The percentage change over time represents inflation or deflation.

CPI vs Other Inflation Measures

CPI isn’t the only way to measure inflation. Here’s how it compares to other key indicators:

• CPIH – Includes owner-occupiers’ housing costs, giving a broader view of inflation for homeowners.
• Retail Price Index (RPI) – An older measure that includes mortgage interest payments. RPI is often higher than CPI and is still used for things like rail fare increases and some pension calculations, but it is no longer considered an official statistic.

Why Does CPI Matter?

CPI isn’t just an abstract economic figure – it has real-world consequences that affect everything from your mortgage to your savings.

1. Impact on Interest Rates

The Bank of England aims to keep inflation at 2%. If CPI rises above this, the Bank may increase interest rates to slow spending and bring inflation back under control.

Higher interest rates mean:

• Higher mortgage repayments for homeowners on variable or tracker deals.
• Higher returns for savers as banks increase interest rates on savings accounts.

2. Wages and Benefits

CPI influences:

• State pensions and benefits – These are often linked to CPI to ensure payments keep up with rising costs.
• Public sector pay – Inflation figures help shape decisions about salary increases.

3. Investment and Business Decisions

Investors closely watch CPI to assess inflation risk. If inflation is high, people may move money away from cash savings into stocks, property, or commodities that tend to perform better when prices are rising.

Why CPI Feels Different for Everyone

Even though CPI gives a national average, inflation doesn’t affect everyone the same way.

• If most of your spending is on essentials like food and energy, rising CPI feels more painful.
• If you’re a homeowner with a mortgage, rising CPI could mean higher repayments.
• If you have cash savings, higher CPI might lead to better interest rates on savings accounts.

This is why inflation above 2% isn’t just about the cost of your weekly shop – it affects housing costs, debt repayments, wages, and pensions, too.

Final Thoughts

CPI is one of the most important economic indicators in the UK. It shapes interest rates, government policies, and household budgets. While the 3% rise in January 2025 will hit different households in different ways, one thing is certain – keeping an eye on inflation is key to making informed financial decisions.