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What you need to know about inflation

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Inflation is a measurement used by governments to help decide future economic policy and set prices and benefits. We explain how inflation impacts you and your money.

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What is inflation?

Inflation is the way we track a rise in the cost of goods and services. It is a figure used to explain how much the prices of everyday essentials have increased over time.

When things cost more – that’s inflation

The rise in the cost of prices over the years is often referred to as “the rate of inflation” or the “level of inflation”.

Inflation measures how much prices have gone up daily, monthly or yearly. It can also be used to compare the prices of things decades or centuries ago – the Bank of England has an inflation calculator which goes back to 1209 when King John ruled England.

How do we know what inflation is?

The Office for National Statistics (ONS) keeps tabs on the rate of inflation in the UK. 

It publishes a regular update showing how much the cost of living has increased (or decreased). For example, if the rate of inflation is 4% a year, then you could estimate that a bottle of milk that cost £1 in January 2022 would set you back £1.04 by January 2023.

The inflation figure is a general one, which uses a basket of popular goods to average out how much the cost of living has gone up.

The basket of goods is frequently updated in an attempt to reflect what we’re spending our money on. 

In 2021, for example, it added hand sanitiser and tracksuit bottoms to its basket of goods as sales of both soared during the pandemic.

Other things drop out - in 2021, the staff restaurant sandwich was removed, as people were increasingly working from and eating at home.

Prices of all the items in this basket are then checked and compared with their costs a year ago, adjusted for how much is spent on them, to come up with an overall figure that we refer to as inflation.

Is inflation going up?

The UK’s rate of inflation has been rising over the past few years, after being at historic low levels over the past two decades. From 2.1% in May 2021, it's more than quadrupled to 40-year highs of 11.1% in October 2022 this year.

Since then it's been sliding lower, dropping to 10.1% by January 2023.

However, inflation has been higher in the past. In 1975, it was 24.2%.

Inflation over time

If you had £1 to spend 20 years ago, you would be able to buy a lot more with it, than you could today. This rise is referred to as inflation and always appears as a percentage figure.

As a very rough guide, an everyday item worth £1 two decades ago would cost around £1.70 now. This is because the average rate of inflation has been 2.9% every year since 2000.

While 2.9% might not seem like much, if the price grows every year it becomes much more expensive over time.

So inflation is a rise in prices, but economists refer to it as a decline in the purchasing power of a given currency because the rise in prices means the currency is worth less - that is, it buys less.

How is inflation controlled?

The Bank of England has been tasked with trying to keep inflation at as close to 2% as possible - which it does primarily through raising interest rates (encouraging people to save more and borrow less) or lowering them (making borrowing cheaper and saving less worthwhile).

The idea is that if people are spending less, shops and other retailers will work harder to keep prices down, while when money is cheap to borrow and savings don’t reward you as much people - and businesses - spend more freely.

A stable, low rate of inflation is seen as the sign of a healthy economy - as small price rises discourage people from hoarding money rather than spending, but large ones see people’s savings effectively destroyed.

If the rate goes above 3% or below 1% the governor of the Bank of England has to send the UK’s chancellor of the exchequer an open letter explaining why inflation has moved away from the target and what action the bank is taking to bring inflation back to where it should be.

While this might work in theory, the bank cannot control increasing costs for things like gas and petrol - where the price is based on international markets and people are forced to buy them regardless of how much they cost.

Why is inflation rising?

At the moment inflation appears to be rising, primarily thanks to the surging cost of petrol, gas and electricity.

The price tag of things like second-hand cars also rose in November. This was because the production of new cars has been slowed by a global shortage of semiconductors used in computer chips. The shortfall was caused by pandemic lockdowns.

The good news is that many of these price rises should be temporary, although there’s no guarantee that will be the case. 

How is inflation calculated?

Each month, the Office for National Statistics (ONS) collects 180,000 prices from a basket of 700 items. 

The items, which are collectively known as a shopping basket, are the most common items purchased in the UK. The prices are collected and then used to work out the Consumer Prices Index (CPI) which is used to measure inflation.

There are two other figures which also play a part in calculating inflation, the CPIH, which is the CPI but with owner occupiers’ housing and Council Tax costs included, and the Retail Prices Index (RPI).

The RPI is largely a legacy measure of inflation. It used to be the main index but was downgraded in 2013, following the Code of Practice for Official Statistics exam that said it failed to meet the required standard for designation as a National Statistic.

Despite this, it is still used to set things like annual rail prices and student loan interest costs.

What items are used to work out inflation?

The inflation shopping basket contains hundreds of items - you can see a breakdown of the full list here.

It covers 12 main areas:

  • Food & non-alcoholic beverages

  • Alcohol & tobacco

  • Clothing & footwear

  • Housing & household services

  • Furniture & household goods

  • Health

  • Transport

  • Communication

  • Recreation & culture

  • Education

  • Restaurants & hotels

  • Miscellaneous goods & services

It’s also remarkably complete, with the goal of being comparable internationally. It even includes illegal recreational substances so that they can be compared to countries where they have been decriminalised or legalised.

The price for each item is then checked each month at a variety of places up and down the county to see how they’ve changed.

These items are then given a “weight”, roughly equal to how much money people spend on them each year on average. The weighted figures are combined to give an overall picture of the cost of living that month and how it’s changed. 

What is stagflation?

Inflation is traditionally seen by many economists as a sign of there being “too much money” in the system - where prices are rising because the economy and wages are growing.

By contrast, “stagflation” is when prices rise despite the economy either standing still or actively falling.

It’s seen as a terrible position to be in - as it means people are being forced to pay more for things, but their wages aren’t rising.

To put it in traditional terms, it means the pound in your pocket buys you less, but the pounds in your pay packet stay the same.

The problem with trying to control inflation in this situation is that if the Bank of England raises interest rates, all it does is mean debts cost more - sucking even more money out of the system and potentially leading to companies going out of business (and people losing their jobs) too.

What is hyperinflation?

Hyperinflation is when prices rise too quickly, and is normally the result of an economic shock or event.

In the worst cases, it can see prices rise by thousands of per cent a month, as more and more money is charged for items as the public lose faith in their currency.

A good example of hyperinflation happened in Germany in the 1920s. 

At only point prices were doubling every four days after a series of disastrous policy decisions by the government.

By 1933 the government was issuing two-trillion mark banknotes and postage stamps with a face value of fifty billion marks.

The highest value banknote issued by the Weimar government's Reichsbank had a face value of 100 trillion marks but was worth just 25 US dollars.

Eventually, the government simply issued a new currency, with an incredible 12 zeros removed.

Is low inflation bad news for savers?

Low inflation means the interest rate paid on cash savings tends to be lower. So people are more tempted to spend their cash than save it. But while your savings might get lower rates of interest, the benefit is that they will be able to buy you about the same amount of goods as when you put the money in the bank in the first place.

Higher inflation means higher interest rates. Making it more expensive to borrow but benefits savers because the interest rate paid on their savings goes up. 

Of course, the benefit of higher rates of interest on your savings only works if what you eventually buy with those savings has risen in price by less than what you earnt from the bank.

That means the key is how the rate of interest on your savings compares to the rate of inflation. Making 10% interest when prices are rising by 15% a year is a lot worse than making 4% interest when prices only rise 2%, for example.

Is low inflation bad for borrowers?

There's a traditional view that high inflation is good for people with debts, as that debt becomes smaller every year relative to prices. However, for that to be true needs two other things to happen as well.

First, the interest on the debt has to be smaller than the rise in prices and, second, your earnings need to rise too.

By contrast, low inflation generally means interest rates are also low, so tends to be cheaper to borrow. Low interest rates also mean more of your repayments go towards the balance of the debt, and less on paying off the interest, too - something that's especially important with something like a mortgage that is repaid over many years.

How does inflation affect me?

If you are a saver 

Keep an eye on the interest rate your savings accounts are paying. If possible you need to make sure you are getting the same interest rate as the rate of inflation so your spending power doesn’t decline. This may be a challenge.

You may be able to take advantage of an introductory savings account rate, but that will go back down after the introductory period ends- so you need to be aware and possibly move your savings to a higher-interest account.

It’s also wise to make sure you get full value out of any interest you earn.

You will not pay tax on the interest earned from an Individual Savings Account (ISA), for example.

If you are an investor

In theory, as companies raising prices is what contributes to inflation, money in stocks and shares is naturally inflation-proof.

However, things don’t always work out that way in practice.

To try and make sure you are protected from rising prices, you can look to put your savings in a fund designed to account for inflation.

If you hear the phrase “a hedge against inflation” that means an investment that tends to rise, or at the very least doesn’t lose any of its value, when inflation rises.

For example, some investors put money into funds that benefit from a rise in the price of gold or other precious metals. The idea is that as their supply is physically limited, their relative value should stay the same when prices elsewhere rise.

If you are a borrower

Rising inflation - if accompanied by rising wages - is actually good news for borrowers, with one important caveat.

If you borrow £100, but inflation is at 10%, then in theory that means at the end of the year that debt is only ‘worth’ £90. If your wages rise in line with inflation then your debt has got smaller.

The caveat is interest rates.

Borrowing is rarely free, and banks are smart enough to raise the interest rates they charge as inflation rises.

To protect yourself from banks raising rates, try and pay down any credit card debts, or make sure you transfer them to a 0% balance transfer card. 

It may be worth looking at fixing your mortgage rate, you can compare mortgage rates and work out what the best deal is for you

How does inflation affect the state pension?

Inflation figures are used to work out how much the UK state pension needs to be increased by each year. The government normally uses September’s CPI to set the following year’s pension increase.

This means state pensions will be increased in line with a CPI of 3.1% during the next year (2022). This means the basic State Pension will increase to £141.85 per week and the full rate of the new State Pension will increase to £185.15.

Around 10 million state pensioners will see their pension go up by £288.60 during the year.

The state pension payment is protected by a so-called ‘double lock’. This means it will increase by the higher of either September’s rate of inflation or the government’s guaranteed minimum of 2.5%.

In previous years the state pension is normally increased by the so-called ‘triple lock’ which also links the state pension to average earnings.

But this has been suspended for at least a year due to the pandemic. 

Is high inflation bad?

Inflation is inevitable in a healthy economy, it means people are earning more and the economy is growing. 

But there is a point where rising inflation can be a problem, if the price of things rises too quickly that can be a sign of an overheating economy.

It can also affect global trade, as export and imported goods rely on the stability of a currency’s value to set prices, so high inflation can prove to be a real problem when nations trade with each other.

Can inflation be controlled? 

Most global economic policy, from the US to China, Europe and the UK, has been led by those countries’ central banks (The Bank of England, The Federal Reserve in the US)  wanting to keep inflation as low and as manageable as possible. It means countries can trade and compete with each other. 

They do this by keeping interest rates, the rate at which money can be borrowed low. This means everyone - from large banks to small companies, to people taking out mortgages and loans for cars -  will pay less interest. If it’s cheap to borrow people tend to spend more and companies tend to buy and produce more.

Sadly, it’s not a foolproof system - and in a global economy, a national bank can struggle, especially when shortages caused by, say, a fire in China mean prices in the UK rise.

Different types of inflation 

If you want to know more about inflation then you might be interested in the work of the economist Robert J. Gordon who introduced the triangle model of inflation.

He believes there are three types of inflation:

Demand-pull inflation

This is when spending increases because of demand. Such as a demand in the need for the price of sanitiser where demand is high but supply cannot be met quickly enough. 

Cost-push inflation

This is when a price rises because there is an increase in the cost of the raw material or production or the cost of the staff needed to make it. For example, there has been a shortage of the ingredients used in the sanitiser or the material used in the bottle. 

It could also be the staff making the bottles are being paid more because the minimum wage has been increased or there is a shortage of workers.

This type of inflation can also be caused by falling exchange rates and increased taxation or even import costs.

Built-in inflation

This form of inflation can be said to be self-fulfilling. If people expect prices to go up then they behave in a way that perpetuates a cycle of never-ending price rises. So staff at the sanitiser factory demand to be paid more in order to meet the cost of living and the business charges more as a result.

If you'd like to read more about inflation and its effects on the cost of living crisis, visit our cost of living statistics page, where we have analysed the latest data and trends.

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About James Andrews 

James is our senior personal finance editor and has spent the past 15 years writing and editing personal finance news. He has previously written for ReachPLC, was money editor of Mirror Online and Yahoo Finance UK, and has recently been quoted in City AM, Liverpool Echo and Daily Record as well as featured on national radio shows TalkRadio and the BBC

View James Andrews’ full biography here or visit the money.co.uk press centre for our latest news.

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