What is inflation?
Inflation measures how much the price for goods and services has gone up over time.
When there’s inflation in an economy, the value of money decreases because people would need to spend more to buy the same products. Put simply, £1 would get you further this year than £1 would next year.
Inflation is the opposite of Deflation.
Changes in the prices of goods and services is usually measured by the Office for National Statistics (ONS) in the UK. Because we use such a diverse range of products in our everyday lives, the ONS will need to compare a diverse range of goods and services too. This includes different types of commodities like food and fuel, utilities like electricity and services like healthcare.
Their aim is to measure any price changes in this diverse range of goods and services over the past 12 months. It’s measured using The Consumer Prices Index (CPI). This allows for a single value representation of how the price level of goods and services in an economy has gone up or down over time. Below we show the history of CPIH which includes owner occupiers’ housing costs.
Source: Office for National Statistics (ONS). June 2022.
Is inflation good or bad?
There are both positives and negatives when it comes to inflation – it all depends on your individual circumstances.
For example, if you’re retired with a set monthly income and the prices of everyday items increase, more of your money will get eaten away by inflation.
It’s the same for people whose wages aren’t increased at the same rate of inflation.
Imagine it usually costs you £100 to fill up the tank of your car. If the rate of inflation on fuel is 2%, next year it could cost you £102 to fill up the tank of your car instead.
This is known as reducing the purchasing power of money.
A little bit of inflation isn’t always a bad thing though.
If there’s inflation in an economy, it encourages people to buy different goods or services sooner. This in turn makes it easier for different businesses to increase people’s wages – both boosting growth to the economy.
Inflation can also help borrowers. Because the purchasing power of money has been reduced, the borrower is technically paying back what they owe with money that has less value than the money they borrowed.
Average price comparison in UK
|June 1992||June 2002||June 2012||June 2022||Litre of unleaded petrol||£0.46||£0.75||£1.32||£1.62|
Source: Office for National Statistics, RPI: Average price June 2022.
What causes inflation?
There can be a number of different reasons for inflation to occur. We usually categorise them into:
- Demand-pull inflation – which is where there aren’t enough products being produced to keep up with demand, so drives up prices.
- Cost-push inflation – happens when the cost of producing products and services increases, so businesses have to raise their prices.
- Built-in inflation – is where employees demand higher wages to keep up with the rising costs of living. Companies then have to increase their prices to pay for the higher wages, creating a spiralling effect between wages and the costs of living.
How is inflation measured?
The inflation rate is usually given as an annual percentage. The common measure of inflation is the inflation rate and is measured by the Office for National Statistics (ONS).
The ONS will measure inflation over a 12-month period by comparing the prices of thousands of things people spend money on, against the price it was a year ago. This is done on a monthly basis. They’ll be able to see an upward or downward price movement and work out an average.
The ONS has three estimates for inflation:
- The Consumer Prices Index (CPI) – this is a standard measure of inflation throughout the European Union (EU). It doesn’t include mortgage interest payments and other housing costs.
- The Retail Prices Index (RPI) – measures the increase in general household spending, including mortgage and rent payments, food, transport and entertainment.
- The Consumer Price Inflation including owner-occupiers’ housing costs (CPIH) – is an inflation measure that’s based on CPI and takes into account housing costs for owners and occupiers.
How does inflation affect interest rates?
In the UK a team within the Bank of England (BoE), called the Monetary Policy Committee (MPC), take the appropriate measures to make sure the rate of inflation is kept within the government’s inflation target.
Because a little bit of inflation is good for a growing economy. For example, here in the UK, the target for inflation is 2%.
One of the best ways to maintain a steady inflation rate is through interest rates. When the BoE are setting the base interest rate, they’ll need to think about how it can affect inflation. The base interest rate will influence different banks and building societies on what they’ll charge people to borrow money, or what interest they’ll pay on people’s savings.
For example, if the BoE thought inflation would dip below its target, it could lower the base interest rate. If interest rates are lower to borrow money, people are more likely to borrow and spend.
On the flip side, if interest rates are high borrowing becomes more expensive and people are more likely to save. Because less is being spent, the growth of the economy should slow down and demand for goods should drop.
If there’s less demand for goods it should make them cheaper, lowering inflation.
What is Hyperinflation?
We know a little bit of inflation is a good sign of a growing economy, but too much of a good thing can turn bad. That’s where hyperinflation comes in.
Hyperinflation is when the prices of goods and services rise too quickly and become uncontrollable. Imagine putting a loaf of bread in your shopping basket, and by the time you got to the checkout the price had doubled.
Sounds extreme, right? You might be surprised by how many times hyperinflation has happened in the past.
It can happen if a government prints more money to pay for its spending, which is likely why some of the worst examples have happened after wars.
It creates a spiralling effect – as there’s more money around, things become more expensive, so the government has to print more money.
One of the worst cases in history was in Hungary in 1946. At the height of Hungary’s inflation, it’s estimated the daily inflation rate stood at 207% percent, with prices doubling every 15 hours.