Inflation hits 4.5% – The figures explained & what they mean for interest rates & your mortgage

UK inflation increased to 4.5% in April, from 4% in March, official figures have shown. But there is a more to this story than this one figure alone.

So what happened?

• The year on year Consumer Prices Index (CPI) inflation measure rose to 4.5% in April, much higher than the 4.1% expected by analysts. CPI is now at its highest level since October 2008.
• However the Retail Prices Index (RPI) inflation measure fell from from 5.3% in March to 5.2% for the year to April.

But what does this all mean? And what’s the difference between CPI and RPI?

Both the CPI and RPI are attempts to estimate inflation in the UK. The RPI measure is arguably the better known in the UK. Sometimes referred to as the “headline” rate of inflation, it is the rate often cited by unions as a benchmark for agreeing pay settlements. It is also the basis for pension increase and National Savings Index linked investments

The CPI measure is the rate the government’s inflation target is based on. It is an internationally comparable measure of inflation and is used as the basis for annual increases in a number of UK state benefits.

Both indexes analyse the prices changes of a range of goods and services over time (referred to as the ‘basket’). Some of the goods and services will carry a higher weighting within the indexes, reflecting the fact that we spend more on some items than others. In addition, the actual items which are included in the basket are reviewed each year and are subject to change (see my post 10 items you’d never guess help determine the official UK inflation figure).

So why do the CPI and RPI values differ?

The answer is that the two measures cover different items. For example, the CPI does not include Council Tax, mortgage interest payments and some other housing costs. The CPI measure also includes some items such as charges for financial services which are not in the RPI. Another difference is that the CPI measure covers a broader sample of the population in its calculations than RPI.

There is also a difference in the mathematics of each index which means that the CPI is always lower than RPI for a given data sample.

As for why the CPI measure increased so dramatically, the Office of National Statistics (ONS) said "by far the largest upward effect" on prices came from air transport, where fares rose by 29% between March and April. Sea fares rose by 22.3%.

So is this bad news? And what does this mean for interest rates?

First of all ignore all the 'interest rates are about to go up' newspaper headlines. Knee jerk reactions are a) worthless and b) ill-advised. You need to consider this data in its wider context.

As stated above, the Bank of England uses the CPI as its inflation measure when making interest rate decisions. Their key job is to keep inflation under control – and one way to do this is to increase interest rates. The problem is that anyone who is not on a fixed rate mortgage deal will see their monthly mortgage payments go up if interest rates increase to combat inflation.

The news that CPI has risen will give the Bank of England cause for concern. But as I wrote, last week, in my article What the Bank of England’s inflation report means for your mortgage rate the Bank of England publicly announced that inflation will likely hit 5% at sometime in the near future. So from that perspective nothing has changed.

The BBC reported Andrew Goodwin, senior economic adviser to the Ernst & Young Item Club, saying ''that almost all of the pick-up in CPI inflation was due to higher transport costs caused by the timing of Easter, and this is likely to unwind next month, Abstract from this issue and the picture is little changed and there are few implications for policy."

And I have to agree. Yes, the latest inflation figures are a cause of concern but nothing has fundamentally changed. But if you want to know when interest rates are likely to rise then read my article Latest interest rate predictions – May 2011.

So should I fix my mortgage?

I have just finished updating my article Reader’s Question: Should I fix my mortgage now? - so follow the link to find out.

Image: Salvatore Vuono / FreeDigitalPhotos.net