What is inflation?

If you’ve ever wondered what inflation is and what it could mean for you, this breakdown explains what you should know in simple terms.

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Inflation: it’s a term we hear fairly often, but it’s not always clear what it means or what it’s for. Most investors assume it’s a bad thing. And while too much can create significant problems, too little can result in stagnant economic growth. Like anything in the investing world, it’s all about balance.

With that in mind, let’s explore the topic in more detail, covering what inflation actually is and what critical factors investors need to be aware of.

What is inflation?

Inflation is all about measuring the sustained rate of price increases over 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%.

In other words, inflation is the devaluation of money and its purchasing power.

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.

Demand-pull inflation

When demand exceeds supply, meaning there’s not enough product to meet consumer demand, prices rise, causing inflation.

Cost-push 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.

Pros of inflation

  • Inflation encourages people to spend more money, which stimulates economic growth.
  • 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.

Cons of inflation

  • 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?

The UK’s CPI inflation rate, as of November 2022, currently sits near a 40-year high of 10.7%. This is due to a variety of factors related to the pandemic, global supply chain disruptions, a geopolitical conflict in Eastern Europe, and the aftermath of Brexit.

The British Chambers of Commerce released a forecast in December 2022 indicating that inflation may have peaked1. And it’s predicting that the UK inflation rate will drop to 5% by the fourth quarter of 2023 before finally returning to the Bank of England’s target rate of 1.5% by the fourth quarter of 2024.

UK Inflation Rate (%)

What’s driving inflation in the UK?

There are a lot of moving parts to every economy. As such, there are multiple factors driving inflation today. However, the primary catalysts seem to be energy and food prices.

Following the Russian invasion of Ukraine, most Western nations, including the UK, have boycotted buying Russian gas and oil. As a consequence of this decision, many European nations are now suffering an energy supply shock, especially countries like Germany, which had become heavily dependent on Russian energy over the last decade.

The UK doesn’t import much oil and gas from Russia thanks to its own oil fields off the coast of Scotland and its more established renewable energy infrastructure. However, the global commodity markets ultimately determine the price of oil and gas.

Therefore, as the price of these fossil fuels increases, so does the cost of generating electricity, resulting in skyrocketing household energy bills. It’s worth pointing out that 41.9% of electricity generated in 2022 came from gas-powered turbines2.

To make matters worse, Ukraine is a world-leading exporter of agricultural products, such as corn, wheat, barley, and rapeseed. In fact, it’s the largest supplier of sunflower oil worldwide, providing 46% of the global supply3.

With this supply line cut, the cost of ingredients for food manufacturers is going up. Meanwhile, British farmers are struggling to make up the difference. The rising electricity costs, paired with a labour shortage exacerbated by Brexit, make farming far more expensive, with costs being passed onto consumers.

What happens if inflation is too high?

In extreme cases, if inflation remains elevated for too long, it can lead to a phenomenon called hyperinflation. This is when rapid and excessive price increases quickly go out of control. It’s typically defined as an inflation rate of 50% or more every month. In other words, the spending power of money halves with each passing month.

Hyperinflation in developed nations is pretty rare. In Europe, the most recent incident of hyperinflation occurred in Germany after World War I. To put things in perspective, a single loaf of bread in Berlin was worth four marks in December 19214. By November 1923, the price had increased to 201,000,000,000 marks. It ultimately led to the complete collapse of Germany’s currency, which was eventually replaced by the reichsmark in 1924 to put an end to hyperinflation.

Needless to say, the UK is unlikely to end up in such a situation. Why? Because the British government and central banks have multiple tools they can use to combat inflation.

What can the government do to control inflation?

The British government has an inflation target of 2%. Why is it not 0%? As previously mentioned, having a small trickle of inflation is beneficial as it stimulates economic growth.

To influence the rate of inflation, the Bank of England needs to step in. It has the power to adjust the base lending rate. This is essentially the interest rate which banks have to pay to borrow money from each other using secured debt obligations. The base rate also influences the London Interbank Offered Rate (LIBOR), which is the interest rate on unsecured debt obligations.

As the cost of borrowing increases for banks, they pass on this additional cost to customers. New business and consumer loans become more expensive, as do existing variable-rate loans. The most common type of debt influenced by this decision is mortgages.

With more consumer capital being gobbled up by interest expenses, there is less left over for discretionary spending. And even some staple goods see reduced demand. In other words, the economy begins to slow. With reduced demand and less spending, inflation can cool off, falling back to ideal levels.

However, raising interest rates can backfire. Suppose the central banks are too aggressive with their rate hikes? In that case, the economy could grind to a halt or even shrink, resulting in a potentially severe recession.

How does inflation affect you?

A spike in inflation means higher living costs, so buying the things you need, such as petrol, is more expensive. You might also find that your bills go up, 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.

What should you invest in during inflation?

Investing during a time of high inflation can be quite a scary experience. After all, inflation and rising interest rates don’t create the ideal business operating environment. And with uncertainty surrounding the economy, asset prices can be significantly volatile.

However, prudent long-term investing is a proven strategy to beat inflation and sustainably build wealth. But which are the best asset classes to buy?

The most popular inflation-resistant asset class throughout history has been real estate. That may seem strange, given that rising interest rates are dragging house prices down. However, for properties that are being leased to long-term tenants, the rental income stream is often reliable.

That’s especially true for business-facing industrial real estate like warehouses. And thanks to the creation of real estate investment trusts (REITs), pretty much anyone with a brokerage account can invest in this type of property.

What about stocks? In some cases, investing in companies can be an even better hedge against inflation. Owning businesses that command significant pricing power can just pass on costs to consumers, protecting their profit margins. While growth may slow, robust margins keep earnings elevated. And with excess capital piling up, these businesses can capitalise on the weakened state of competitors and capture more market share.

There are also certain industries that are generally considered to be “recession-proof”. The healthcare sector is one such example. Why? Because regardless of the cost, price is usually an afterthought if an individual needs urgent medical assistance.

Similarly, the consumer staples, utilities, and energy sectors often outperform during times of higher inflation. However, one caveat to consider is that these defensive industries typically underperform when inflation has cooled off.

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