How to use inflation statistics in pay setting

89.8% of organisations think that inflation is going to put upward pressure on pay awards over the coming year.

XpertHR survey data

While most organisations report that they look at inflation data when setting budgets for and agreeing their pay reviews, this year’s outturns have proved particularly challenging for pay setters. Inflation on both the retail prices and consumer prices measures has rocketed over the past year, leaving the real value of most pay rises in tatters.

Use this guide to understand the different inflation measures to which both employers and employees will refer, and how pay awards have fared in relation to the increases in prices over the past few years.

Introduction

Historically, movements in inflation have been keenly watched by both the employee and employer sides of the pay bargaining table. Securing an annual pay rise that matches or exceeds the cost of living has long been an objective in trade union bargaining. While many employers now seek to link pay rises to performance or market rates rather than inflation, a majority still take the inflation rate into account when carrying out an annual pay review. According to the latest XpertHR survey data, 89.8% of organisations think that inflation is going to put upward pressure on pay awards over the coming year.

Inflation statistics are published each month by the Office for National Statistics (ONS). This guide explains the statistics available and how employers might use them when conducting a pay review.

What is inflation and how it is measured?

Inflation is the speed at which the prices are going up or down in the economy. A price index is a way of measuring it. The types of indices published by the ONS include:

• consumer price indices, which measure the changing prices of goods and services to the consumer;
• producer price indices, which measure the prices of goods bought and sold by UK manufacturers;
• service producer price indices, which do the same for services firms in the private sector; and
• the house price index, measuring changes in the average price of a house.

They can all be found on the ONS website. Inflation indices are important indicators of how the economy is performing. They are used in a variety of ways by the Government in setting economic policy, but also for the uprating of some benefits, pensions, gilts, rail fares and utility prices.

Consumer price inflation and the “shopping basket”

The indices of most relevance to employers when looking at the level of employees’ pay are those relating to consumer prices, as they reflect the cost of living and the purchasing power of their employees.

The two most important consumer price indices are the consumer prices index (CPI) and the retail prices index (RPI), but a number of other measures are based on these two indices.

A useful way of thinking about both the RPI and the CPI is to imagine a “shopping basket” containing the goods and services on which people typically spend their money. As the prices of the various items in the basket change over time, so does the total cost of the basket. Movements in the CPI and the RPI represent the changing cost of this basket. Each year, the ONS reviews this basket (some items are taken out of the basket and others are brought in) to ensure that the indices reflect the latest spending patterns.

What are the main consumer price indices?

The main measures of UK consumer price inflation – and those reported on the XpertHR economic indicators page (see Inflation) – are the following.

CPI

The CPI is the UK’s main domestic measure of consumer price inflation and is an internationally comparable measure. It forms the basis for the Government’s target for inflation that the Bank of England’s Monetary Policy Committee (MPC) is required to achieve. The official CPI series starts in 1996, but estimates for earlier periods are available back to 1988. The CPI excludes certain housing costs, such as owner-occupied housing and council tax.

RPI

The all-items RPI is the oldest measure of UK inflation, with data going back to 1947. Unlike the CPI, the RPI includes housing costs, such as mortgage interest payments, buildings insurance and council tax. Spending by pensioner households is not included in the sample used nor is that of the top 4% of households by income. While it is used for a wide variety of purposes, in March 2013 the ONS declared that the RPI did not meet international statistical standards because of a formula used in its calculation, called the Carli formula (for more information see National Statistician announces outcome of consultation on RPI on the ONS website). Its status as a national statistic was removed on 14 March 2013, but the ONS continues to publish it in an annex to the official figures because of its uses in long-term indexation, such as for index-linked gilts and bonds.

CPIH

A new measure of inflation called CPIH was first published by the ONS on 19 March 2013, initially on an experimental basis. On 14 August 2014 the ONS announced that CPIH would no longer be designated as a national statistic. CPIH is the same as CPI except that it includes owner-occupier housing costs, an important omission from the CPI as these costs account for around 10% of total UK household expenditure. They are calculated using a “rental equivalence” approach, using the rent paid for an equivalent house in the private sector as a proxy for the costs faced by an owner-occupier. From March 2017 Council Tax was incorporated CPIH. From 21 March 2017 the ONS will use CPIH as its preferred measure of inflation, and will continue its ongoing work to see it designated as a national statistic.

RPIX

The RPIX is the same as the all-items RPI except that it excludes mortgage interest payments. It was used as the Government’s inflation target prior to the switch to CPI in 2003. It provides a guide to underlying inflation because it ignores the effect of changes in mortgage costs when interest rates rise or fall. Like the RPI, it was stripped of its “national statistic” status on 14 March 2013.

Other inflation measures

In March 2017, the ONS announced that it was ceasing publication of lesser-used consumer price indexes including the consumer prices index excluding indirect taxes (CPIY), the retail prices index excluding mortgage interest payments and indirect taxes (RPIY), the RPIJ (an experimental series of RPI based on the Jevrons measure of calculation), and the tax and price index (TPI).

Advantages and disadvantages of the different inflation measures

The RPI has historically run at a higher level than the CPI, so in general a wage settlement linked to the RPI will be higher than one linked to the CPI. The RPI has the advantage of being a long-established indicator and the one with which both employees and employers are most familiar. However the January 2013 announcement from the ONS that the RPI did not meet international statistical standards – and the removal of its “national statistic” status – may cause some employers to pay more attention to other measures of inflation.

As the Government’s preferred measure, the CPI is likely to remain the most important inflation benchmark in terms of economic policy. But for the purposes of wage bargaining, the disadvantage of this measure is that it does not include owner-occupier housing costs, so may not be seen as capturing the cost of living as effectively as the RPI by employees. There is now, however, a CPI measure that takes account of these costs, in the form of the CPIH, which employers may choose to look at and which the ONS now uses as its headline measure.

Other measures based on the RPI, such as the RPIX, will continue to give a guide to underlying inflation, but users should bear in mind that they will continue to be calculated in the same way as the RPI.

How do employers use inflation?

The RPI has historically been the most commonly used inflation measure when it comes to pay setting, but in recent years more employers have been paying attention to the CPI as well. XpertHR research in September 2022 found that most private-sector employers said that they would refer to one or more measures of inflation in the coming pay round. When questioned on which measure of inflation would be referred to, 39.6% reported that they would refer to the RPI, while more (51.7%) would use the CPI – more often than not employers will use a combination of the different inflation measures.

Very few employers implement pay awards that include an explicit link to current or future inflation. Traditionally this is done in the form of an inflation-plus award, such as RPI inflation plus 0.5%, for example, often in the second or third year of a long-term pay award. Where this type of pay agreement is used, it sometimes includes a “cap” or “collar” to prevent an inflation-linked pay rise falling below or above a particular level should inflation turn out to be much higher or lower than expected. Another way of coping with unforeseen movements in the inflation rate is to include a “reopener clause” that allows negotiations on the latter stage of a pay deal to be resumed should inflation fall above or below a particular level.

Some employers choose to use an average of a number of different measures of inflation at a particular point in time or over a specified date period. If there is an explicit inflation link in the pay award, the organisation needs to decide whether the pay award will be pegged to inflation averaged over a particular period of time, at the time of the pay review or prior to it. Inflation forecasts can help employers to judge the path inflation is likely to take over the coming year.

Inflation statistics on XpertHR

Inflation shows the most recent inflation statistics as well as forecasts from leading economic institutions and City economists.

Pay awards and inflation

Pay awards have been running behind RPI inflation since January 2021, but the gap between the two measures has grown considerably since the beginning of this year. In the three months to the end of August 2022, the 8.3 percentage point shortfall between the XpertHR headline pay award of 4% and retail prices index inflation of 12.3% is the largest we have recorded since our records began in 1984. The 5.9 percentage point gap to consumer prices index inflation (CPI) is slightly smaller than recorded last month (given the fall in CPI inflation) but is still one of the largest since the first reporting of CPI in January 1998.

Relationship between pay awards and inflation, 2017 to 2022