How much CPI(H) underestimates inflation
There are three main areas which probably cause CPI(H) 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(H) 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.
The impact of OOH on CPIH
In addition to the above, Owner Occupiers’ Housing costs (OOH) are also often acting to reduce the main headline measure of inflation (CPIH) still lower in the UK. This is because ONS are consistently measuring the average UK rent rises used in OOH to be around 2% or less. Therefore when CPI is above 2%, OOH act to reduce the CPIH headline rate. The effect has been variable, but generally for every 1% CPI is above 2%, it reduces CPIH by about 0.25%. See chart below and full discussion here.