Inflation affects everything from mortgages to the cost of our shopping and the price of train tickets.
In April, UK inflation hit its lowest since August 2016 as the economic fallout of the coronavirus lockdown hit prices.
But what exactly is inflation and what impact does it have?
What is inflation?
Inflation is the rate at which the prices for goods and services increase.
It’s one of the key measures of financial wellbeing because it affects what consumers can buy for their money. If there is inflation, money doesn’t go as far.
It’s expressed as a percentage increase or decrease in prices over time. For example, if the inflation rate for the cost of a litre of petrol is 2% a year, motorists need to spend 2% more at the pump than 12 months earlier.
And if wages don’t keep up with inflation, purchasing power and the standard of living falls.
A little inflation, however, typically encourages people to buy products sooner and makes it easier for companies to put up wages. And both of those things boost economic growth.
That’s why most countries’ central banks have an inflation target of between 2% and 2.5%.
In the UK the target is 2%. However, in April 2020 inflation fell to 0.8% – the lowest rate since August 2016. Falling petrol and diesel prices, plus lower energy bills, were the main reasons inflation fell.
How is inflation measured?
Inflation is measured by the Office for National Statistics (ONS).
It produces three main estimates of inflation:
- the Consumer Prices Index (CPI)
- the Consumer Prices Index including owner-occupiers’ housing costs (CPIH)
- the Retail Prices Index (RPI)
The CPI is the most commonly quoted figure.
It looks at the prices of thousands of things consumers commonly spend money on, including cinema tickets, bicycles, and even smart-speakers.
The prices are weighted, giving more prominence to what consumers spend more on. So, fuel can affect the inflation rate more than the price of stamps, for example.
CPIH is the ONS’s preferred measure. It builds on CPI to include various costs associated with living in your own home, such as council tax.
RPI, a measure that has fallen out of favour with economists, includes some housing costs but doesn’t account for some people switching to cheaper products when prices rise.
Every year, the RPI figure for July is used to determine how much some train fares will increase by. In 2019 it was 2.8%, which was more than the 2.1% recorded by the CPI measure.
Passenger groups have argued for a change in the way fares are determined, as RPI is no longer a national statistic.
What is it used for?
Inflation is one key factor the Bank of England considers when setting the “base interest rate”. That influences what rate banks can charge people to borrow money, or what they pay on their savings.
If the Bank of England thinks inflation is likely to be below 2%, it may cut interest rates to lower the cost of borrowing and therefore encourage spending.
In response to the coronavirus pandemic, the Bank has cut interest rates to an historic low of just 0.1% to try to lend support to the economy.
Inflation also has a direct impact on some people’s incomes.
State benefits and many occupational pensions rise in line with CPI. The basic state pension is currently governed by the so-called triple-lock. This means it rises by whichever is the highest – CPI, average earnings or 2.5%.
As well as the cost of some train tickets, repayments on student loans and bonds issued by government are also pegged to RPI.
Does anyone benefit from inflation?
It’s important to keep in mind that inflation is only an average rate that looks at certain products.
The way it affects a household’s finances depends on its individual circumstances.
It can benefit borrowers. For example, anyone with a fixed-rate mortgage benefits from inflation, as it effectively reduces their debt.
Governments might also benefit as high inflation eats away at the value of their debts.
However, for savers – including those planning for retirement – inflation cuts how far their money will go in the future.
Rising prices might mean businesses need to renegotiate the wages of workers, who need more money to get by. If inflation is higher than expected, it can also put companies off investing, if they’re uncertain about future costs and demand.
What is hyperinflation?
When prices of goods or services are out of control and rise very quickly, that’s referred to as hyperinflation.
It can happen if a government prints more money to pay for its spending. As there’s a larger supply of money around, prices increase, and so the government prints more money.
It creates a spiral that is extremely difficult to get out of.
The most famous example came when, after World War One, Germany was left with high debts. The government printed more of its own currency to pay them off.
But the currency lost its value and inflation reached 29,500% a month in October 1923. Eventually, the government had to introduce a new currency to get prices under control.
Runaway inflation continues to affect countries today.
In Zimbabwe, inflation peaked at 500,000,000,000% in 2008, which meant the government had to abandon the Zimbabwean dollar. It announced the return to a national currency last June.
Venezuela has also seen skyrocketing inflation. The annual rate is currently 15,000%, according to the International Monetary Fund.