What is the inflation rate? Which costs are increasing the most rapidly? Why are prices growing so quickly?

The “cost of living crisis” refers to the United Kingdom’s experience of declining real disposable incomes (adjusted for inflation, taxes, and benefits) since late 2021.

The government has taken multiple measures to address the crisis throughout this and the previous year. In 2022/23, they provided £59.8 billion in household income support, and an additional £21.5 billion is expected to be spent in 2023/24.

The Spring Budget announced the latest updates on support, including an extension of the Energy Price Guarantee (EPG). However, due to the recent decline in the energy price cap, this support will now end. Household incomes are not keeping up with rising living expenses, and they are not expected to return to their 2021 levels until 2027.

What is the inflation rate?

To calculate inflation, the average change in the price of typical products and services purchased by UK households over one year is measured. The Consumer Price Index (CPI), calculated by the Office of National Statistics, monitors this. They use a sample of 180,000 prices for 700 commonly purchased consumer goods and services. According to the latest data, the current CPI for the 12 months ending in May 2023 is projected to be 8.7%. The Bank of England aims to maintain the CPI inflation rate at 2% plus or minus 1% (between 1% and 3%) and adjusts interest rates accordingly.

What is the outlook for inflation in the coming months?

Since reaching its peak in October 2022 at 11.1%, inflation has been gradually declining, with a temporary increase in February. The Bank of England predicts a sharp decline in inflation this year, but according to their latest forecast, it will not return to the 2% target until 2024. Additionally, both projections indicate that inflation will remain below 1% until 2026.

Which costs are increasing the most rapidly?

Since February 2022, the rise in wholesale petrol prices has significantly contributed to overall price increases, leading to a rapid surge in energy costs. In May, housing and household services (including electricity and gas), as well as food and non-alcoholic beverages, contributed the most to annual CPIH inflation.

If the government had not intervened with the Energy Price Guarantee to limit the unit cost of electricity and gas, the average household’s energy bill would have exceeded £4,000. Price increases have become more widespread in the past year. For example, based on average consumption levels, the average annual petrol bill in 2022 was £1,100, nearly double the £600 average in 2021.

Wholesale energy prices have reached their lowest level since last spring, as reflected in Ofgem‘s most recent price limit of £2,074 per year for the typical household. This is now below the expiring EPG limit of £2,500 on 1 July.

Throughout this and the previous year, price increases have become more widespread. Between May 2022 and May 2023, the prices of bicycles and plumbing services increased by 1%, while milk, eggs, frozen vegetables, and air travel experienced an increase of over 27%.

Why are prices rising so quickly?

Since the middle of 2021, various factors, such as depleted gas supplies in Europe and semiconductor shortages in Asia, have caused cost pressures. Alongside the pandemic’s effects, disruptions to global supply chains have also contributed to price increases.

The primary factor driving the rising prices is the Russian invasion of Ukraine. Many multinational corporations have ceased operations in Russia due to economic sanctions or to avoid reputational damage.

This conflict has led to a shortage of Ukrainian exports, including essential auto parts, resulting in increased costs for used automobiles. Ukraine primarily exports agricultural products like maize and sunflower oil, and their disruption has contributed to global food price increases.

The most significant impact has been on gas prices, as Russia has drastically reduced its gas exports to Europe. Although the United Kingdom imports only about 13% of its total fuel (oil, gas, LNG, and electricity) from Russia, it is still vulnerable to any disruption in Russia’s energy supply to the European Union, which relies more heavily on Russian energy. Due to energy market integration, gas and electricity prices in the UK and EU move together.

The recent announcement by the European Commission to phase out crude imports from Russia is likely to increase prices in other markets utilized by the United Kingdom, such as Norway and Qatar. Gas is a crucial energy source in the UK, with nearly 80% of homes in England heated by mains gas, and a third of the nation’s electricity generated in gas-fired power plants.

Are incomes growing at the same rate as prices?

In general, no. Inflation is outpacing nominal wage increases, resulting in declining real incomes. Wage growth has not kept up with inflation since the summer of 2021. Between February and April 2023, the average increase in total pay was 5.8%.

The Office for Budget Responsibility (OBR) projects a 5% increase in nominal earnings by 2023, but inflation is expected to erode these gains despite its anticipated decline. Real household disposable income (RHDI), which measures total household earnings (including wages and benefits) after taxes and adjusting for inflation, declined by 2.5% in 2022 and is projected to decline by another 2.6% in 2023.

In April 2023, the incomes of 11 million households receiving income support from the government through working-age benefits or state pension were increased. This increase was 10.1%, matching the CPI inflation rate in September 2022, the reference month for calculating annual increases. In April 2022, the increase was only 3.1%, matching the September inflation rate.

In addition to the Energy Price Guarantee and previous government measures, the one-time Cost of Living Payments 2023/24 provide targeted assistance to the most disadvantaged. However, this approach may leave gaps and cliff edges in support, where those just above the eligibility threshold receive no assistance.

Which households are hardest hit by the rising cost of living?

Some households face a higher effective inflation rate because they spend a larger portion of their income on energy and food, which are experiencing rapid price increases. Poorer households are estimated to spend a greater proportion of their income on these necessities. Based on ONS price data from November, the Resolution Foundation estimates that the inflation rate for the poorest 10% of households is 12.5%, compared to 9.6% for the wealthiest 10%.

Wealthier households experiencing significant price increases in the goods and services they purchase may have more flexibility to adapt, such as by reducing savings or adjusting spending on non-essential items.

The government is providing additional assistance to those with lower incomes through direct compensation, but the anticipated decline in real household incomes means that low-income households will continue to face hardship.

According to the Joseph Roundtree Foundation, 75% of the lowest 20% of low-income households in the UK (4.3 million) have been going without essentials.

Overall, the households most affected by the rising cost of living are those with low incomes and higher-than-average energy costs, such as those with large families. While this group receives significant benefits from the energy price guarantee, on average, they still bear a greater burden due to the crisis.

How long is the expected duration of the cost of living crisis?

As inflation rates decline, living expenses are projected to increase at a slower pace than household incomes by 2024. It’s important to note that declining inflation indicates prices are rising less rapidly, not falling.

According to the most recent projections, it will take a considerable amount of time for household incomes to return to their previous levels in real terms. The indicator of living standards, known as real household disposable income (RHDI) per person, is expected to revert to its 2021/22 level by 2027/28. Even in that year, basic living standards will still be below pre-pandemic levels, indicating that the effects of the cost of living crisis will be felt for an extended period.