We’ve all heard of inflation, but what is it? Why is it important? And how is inflation measured? Here’s what you need to know.
Inflation: what is it?
Before looking at how inflation is measured, let’s understand what inflation actually is.
Inflation refers to the rate at which the prices of goods and services are rising. For example, if the price of petrol rises from £1 to £1.10 per litre in a year, we can measure the yearly inflation rate for petrol at 10%. Similarly, if the price of a typical haircut goes from £20 to £25, then haircut inflation is 25%.
It’s worth knowing that personal rates of inflation vary. For example, if petrol prices rise by 10% in a year, but public transport costs rise just 1% in the same timeframe, someone who drives will be affected more than someone relying on the bus.
While inflation is measured every month, it can be difficult to notice, especially in the short term.
The opposite of inflation is deflation. This is where goods and services become cheaper over time.
What drives inflation?
Factors influencing inflation may include:
- Surges in demand for particular goods or services
- Bank of England monetary policy (such as quantitative easing and base rate policies)
- Wage growth
- Increases in the cost of raw materials or production
For other factors that can influence inflation, see our article that covers what inflation is.
How is inflation measured?
The government and the Bank of England use the Consumer Price Index (CPI) in order to measure inflation.
The CPI is provided by the Office for National Statistics. Often referred to as a ‘typical basket of goods’, it’s calculated by looking at price rises for thousands of goods and services.
This basket changes every year as the ONS adds and removes items in line with changing spending habits across the country. Higher value goods in the CPI will have more of an influence on the overall inflation figure than cheaper goods.
The ONS releases its measure of inflation each month. In June 2021, the figure stood at 2.5%, its highest for almost three years.
The CPI isn’t universally loved though. That’s because some critics believe it gives an inaccurate figure as to the true inflation rate, given that it does not consider price rises in fixed assets, such as shares or property.
What can the government do to control inflation?
The government has an inflation target of 2%. To influence the rate of inflation measured, the Bank of England has the power to increase and decrease its base rate. The base rate is the rate at which banks can lend to one another.
A low base rate makes borrowing cheaper, while a higher rate makes it more expensive to take on debt.
When the economy starts to show signs of rising inflation, above 2%, the Bank of England faces pressure to increase its base rate. This is because increasing the rate can effectively cool down the economy, as a result of making it more expensive to borrow.
Why is measuring inflation important?
Government economists pay close attention to how inflation is measured. This is because it provides a good indicator of the health of the economy. For example, rising inflation may signal that UK Plc is heading in the wrong direction.
However, rising inflation may also indicate a short-term shortage of goods, or could be a short-term side effect of an economic recovery.
Is high inflation bad?
When measuring inflation, the government generally sees a small uptick in a positive light. That’s because stable, small inflation helps businesses and individuals plan for the future and manage their spending accordingly.
For example, in Germany, in the 1920s, banknotes became worthless following ineffective government policy. In a similar vein, Zimbabwe experienced a mind-boggling 80 billion% inflation rate in the early 2000s.
While these stories of hyperinflation probably won’t ever be experienced in the UK, they’re good examples of what can happen if the inflation rate gets out of control.
That said, high inflation can be positive for those with debts. That’s because rising inflation effectively devalues money. So if you owe a hefty sum, high inflation effectively reduces the value of your debt.