Inflation: it’s a term we hear fairly often, but it’s not always clear what it means or what it’s for, so here’s an overview.
What is inflation?
Inflation is all about measuring the rate of price increases over a period of time. We might talk about inflation when the costs of goods and services go up.
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%.
What is deflation?
If inflation means a rise in prices over time, deflation is how we describe a fall in prices. In short, inflation means prices go up, and deflation means they fall.
What is the inflation rate?
The inflation rate is simply the measurement of how much prices increase over time. So, if there’s inflation and we want to know how much prices are rising, we need to know the inflation rate.
What causes inflation?
Factors that influence 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
We can explain this further by looking at the two main types of inflation: demand-pull and cost-push.
When demand exceeds supply, meaning there’s not enough product to meet consumer demand, prices rise, causing inflation.
Cost-push inflation occurs when the cost of raw materials goes up. So, if it costs more money to make things today than it did before, prices rise.
To be clear, prices can vary for many reasons, and it’s not always down to inflation. It’s inflation when there’s a general trend towards higher prices across the whole economy.
How is inflation measured?
The Office for National Statistics (ONS) measures inflation in the UK. The ONS produces various measurements , including the Consumer Price Index, the Consumer Price Index with Housing and the Producer Price Index.
Consumer Price Index (CPI)
The CPI measures changes in the prices of goods and services over time, such as petrol and food. This index is the ‘official’ measure of UK inflation and it helps the Bank of England set inflation targets.
Consumer Price Index with Housing (CPIH)
The CPIH is, technically, the most complete measure of UK inflation. It includes:
- The changing costs of goods and services
- The changing costs of owning and maintaining a UK home.
The CPIH includes council tax and other costs associated with living in a UK property.
Producer Price Index (PPI)
The PPI measures changes in the prices of products bought and sold by UK manufacturers. Higher prices could mean consumers pay more for goods, whereas lower prices could mean they pay less.
What are the pros and cons of inflation?
Inflation isn’t always a bad thing. Here’s a look at the pros and cons.
- Inflation encourages people to spend more money, which keeps the economy going.
- If wages keep pace with inflation, there’s a rise in living standards and spending power.
- When there’s more consumer demand, sellers raise prices, which benefits businesses.
- If wages don’t keep up with inflation, living standards drop and spending power falls.
- Even if wages do rise, it’s harder to save or invest because the cost of living also increases.
- Over time, high inflation can reduce the value of savings.
What’s the UK’s inflation rate?
Right now, the UK’s inflation rate sits at 5.4% due to factors such as the Covid-19 pandemic and rising wholesale energy prices. Inflation is predicted to hit 6% by the spring. However, the Bank of England expects the rate to fall after this point.
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 that inflation will rise 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 by making it more expensive to borrow.
How does inflation affect you?
A spike in inflation means higher living costs, so it’s more expensive to buy the things you need, such as petrol. You might find that your bills go up, too, and it’s tougher to plan your household budget.
What’s more, inflation can raise house prices, so it’s harder to move, buy a first home or find a mortgage.
Finally, if you are a saver, high inflation can erode your savings because your money doesn’t go as far.
How can you beat inflation?
While we can’t escape all the side effects of inflation, here’s how you might minimise its impact on your finances.
1. Have an emergency fund
Ensure you have an emergency fund in a savings account to cover unexpected bills. Check out our guide to savings accounts to start building your emergency fund today.
2. Have a ‘low-spend’ month
A ‘low-spend’ month, where you only spend to cover essentials, can be helpful in times of inflation. Consumer demand can push up prices, so by shopping less, your efforts could help bring demand (and inflation) down.
3. Put your spare cash to work
If you have spare cash that you don’t need immediately, think about how else you could make it work for you. For example, you might consider investing (although no investment is without risk, and it’s important to remember that you might not get back what you put in).
Check out our top-rated brokers to put your cash to work for you.