How much CPI underestimates inflation
There are three main areas which probably cause CPI to underestimate inflation in the UK. Each of them is discussed in detail elsewhere on this site:
- Coverage issues (the lack of housing elements)
- Calculation issues (the use of geometric means)
- Substitution issues (hedonics and chain-linking).
The total underestimation of true inflation is around 1 to 1.5 per cent. The exact amount is variable and there is no simple consistent adjustment that can be made to determine it. This implies that when CPI is at its target of 2 per cent, inflation in the UK is truly around 3-3.5 per cent. The key components of the difference are listed in the table below:
Source: ONS for housing and geometric means effects. Author best estimates for substitution effects.