There are lots of different measures of inflation in the UK. We focus on three when producing our forecasts because they directly or indirectly drive elements of our public finances forecast.

We produce forecasts for the Consumer Prices Index (CPI inflation) and the Retail Prices Index (RPI inflation). The Government uses these measures in various ways. It has set the Bank of England’s inflation target in terms of CPI inflation. In terms of tax and spending, if the Government has not set another specific policy, CPI inflation is used in the income tax system to set the path for allowances and thresholds each year and in the social security system to uprate statutory payments for most working-age benefits while RPI inflation is used to set the path for most excise duty rates. RPI inflation also determines the amount of interest paid on index-linked government debt and the amount owed by students on loans received from government.

As well as forecasting these relatively familiar monthly inflation measures, we also need to forecast inflation at the whole economy level in order to produce a forecast for the cash size of the economy, which is the most important driver of our tax forecasts. The GDP deflator includes not only inflation related to consumer spending, but also to investment, trade and the activities of government.

The forecast process starts by thinking about CPI inflation prospects in the short and medium term, with these timeframes being approached in a different way. That provides the basis for our RPI inflation forecast (which is produced by making various adjustments to get from CPI to RPI) and is the largest component of our GDP deflator forecast (which is produced by adding on forecasts for the other components of the whole economy deflator). The adjustments needed to get from CPI to RPI also allow us to forecast RPIX inflation.

  • CPI inflation

    To forecast CPI inflation, we do three things:

    • First, we produce a short-term forecast – extending over the next year or so – that is compiled from the bottom up by considering prospects for different elements of inflation and weighting them to get to a forecast for overall CPI inflation.
    • Second, we produce a medium-term forecast that is determined from the top down and uses the Bank of England’s 2 per cent target is the anchor.
    • Third, we add on the effects of new policies announced by the Government that we expect to affect inflation.

    It is important to note that in each forecast we make judgements about how much weight to put on each of these approaches and any other factors that we expect to influence inflation prospects. Not all drivers of inflation will have the same effect on prices at all times, so we always need to consider each development on its merits – the forecast process is not a mechanical one of feeding new information into a model and letting it provide the answer.

    Our short-term inflation forecast is broken down into several parts:

    • food and non-alcoholic beverages – these make up 10.3 per cent of the CPI. This forecast is based on the past relationship between these prices, the exchange rate and global commodity prices. For the forecast, we assume sterling will move in line with interest rates in the UK and overseas, while we use IMF forecasts for commodity prices.
    • utility prices – 3.5 per cent of CPI. This forecast is based on wholesale futures prices and information provided by the Department for Business, Energy and Industrial Strategy.
    • road fuel and other transport services – 7.3 per cent of CPI. The main element of this forecast is petrol and diesel prices, which are influenced by global oil prices, the exchange rate and fuel duty policy.
    • rent – 7.2 per cent of CPI. This forecast has two parts. Social rents are based on future local authority housing policies (consistent with assumptions in our fiscal forecasts). Private rents are assumed to rise in line with average earnings.
    • education – 2.5 per cent of CPI. Over recent years it has been affected by significant increases in university tuition fees, which pushed up education services inflation. Absent other policy changes, rises in these fees are assumed to be related to RPIX inflation.
    • tobacco and alcohol – 4.2 per cent of CPI. This forecast is heavily influenced by Government policy on tobacco and alcohol duty rates.
    • other tradable goods – 39.9 per cent of CPI. This forecast covers items that are relatively import-intensive. It is based on the past relationship between these prices, the exchange rate and, in the medium term, domestically generated inflationary pressures arising from costs of production and the size of the output gap.
    • non-tradable goods and services – 25.1 per cent of CPI. This forecast covers items that are relatively less import-intensive, including most services prices. Transport services in this category are influenced by our forecasts for oil prices, while labour intensive services are influenced by outlook for whole economy average earnings.

    Beyond the short term, our CPI inflation forecast is more judgement driven. Typically, by around the third year of the forecast we will assume that inflation returns to the Bank of England’s 2 per cent target. On the assumption that future shocks are as likely to push inflation up or down, our central forecast is typically that inflation remains at target thereafter. The path of inflation back to target is informed by the short-term forecasts described above, our forecasts for unit labour costs and the output gap, and cross-checks against various statistical models.

    Our latest forecast was published in March 2017.

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  • RPI inflation

    The RPI measure of inflation differs from the CPI measure in a number of ways. One of these differences – the formula used in its construction – means that RPI does not meet international statistical standards[1]. It is typically higher than CPI inflation, with the difference between the two measures described as the ‘wedge’. We have published detailed analysis of the sources and size of this wedge, which relate not only to the formula effect, but also its coverage (RPI is slightly broader), different weighting of items in each index and some housing related variables not covered by CPI.

    Our RPI inflation forecast is produced by adding a forecast for the wedge to the CPI inflation forecast described above. Some elements of the wedge are fairly constant over time, but others vary, with prospects for mortgage interest payments and other housing-related elements key sources of variation. These elements are forecast on the basis of our judgements about house prices, mortgage interest rates and mortgage debt.

    [1] ONS, Response to the National Statistician’s consultation on options for improving the Retail Prices Index, February 2013

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  • RPIX inflation

    RPIX inflation is a measure that excludes the mortgage interest payments component from RPI. Our forecast is therefore straightforwardly calculated from the steps taken to produce the headline RPI inflation forecast.

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  • The GDP deflator

    The GDP deflator is the broadest measure of domestic price movements and reflects the price of domestic value added in its entirety. It is comprised of the prices of all domestically produced goods and services in the economy – including the prices of consumption goods and services (closely linked to CPI inflation), investment goods, government services, and exported goods and services, minus the price of imported goods and services.

    To forecast the GDP deflator, we weight together forecasts for each of its components:

    • the private consumption expenditure deflator (65 per cent of the overall GDP deflator in 2015) forecast is largely determined by our forecast for CPI inflation, plus an adjustment for imputed rents, which are assumed to rise at their historical average rate;
    • the export and import price deflator (31 and minus 33 per cent) forecasts are each built up from forecasts for services, goods and oil prices. These are influenced by our forecasts and assumptions for the exchange rate, oil and other commodity prices, domestic labour costs, and foreign country inflation;
    • the government consumption deflator (20 per cent) forecast reflects the way in which these prices are calculated in the National Accounts. One-third of the deflator is measured directly (i.e. using a specific price index), with the remaining two-thirds based on inferred prices (i.e. cash spending is divided by a direct measure of output, like the number of pupils taught, to calculate the price). On the basis of this measurement, we generally assume that one-third of any change to the forecast for nominal government consumption is reflected in volumes, with the remaining two-thirds accounted for by the deflator. We sometimes relax this assumption if we judge that applying it to the Government’s stated fiscal plans would lead to an implausible path for the overall GDP deflator, given that this would also affect our forecast for nominal GDP;
    • the investment deflator (17 per cent) forecast is informed by trends in its components (e.g. business investment and dwellings investment), as well as the outlook for consumer prices; and
    • the forecast for the implied deflator for the change in inventories (typically less than 1 per cent) is largely judgement driven in the short term, while in the medium term is generally assumed to grow in line with the rest of the GDP deflator.

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