What Is Inflation?

What is inflation?

Inflation is the rate at which prices across the economy rise over time. If inflation is 3%, things cost roughly 3% more than they did a year ago, a £50 shopping basket now costs £51.50. In the UK, inflation is officially measured by the Consumer Prices Index (CPI), published monthly by the Office for National Statistics (ONS). The Bank of England targets a 2% CPI inflation rate.

A small amount of inflation is actually considered healthy, it encourages spending (why buy something tomorrow when it costs more?) and gives businesses confidence to invest. The problem comes when it gets too high, or when it falls so low it tips into deflation.

How is inflation measured in the UK?

The main measure is the Consumer Price Index (CPI). The Office for National Statistics (ONS) tracks the prices of around 700 goods and services, a virtual ‘basket’ of things households typically buy, from bread and fuel to cinema tickets and laptops. Each month they measure how much that basket has changed in price compared to a year ago.

You might also hear about CPIH (which adds housing costs like rent) and RPI (an older measure still used for some rail fares and student loan interest). CPI is the official government and Bank of England measure.

What does inflation mean for your money?

Inflation erodes the real value of money over time. If your savings earn less interest than the inflation rate, your money loses purchasing power even as the balance grows. A 2% pay rise when inflation is 5% is effectively a real-terms pay cut. Inflation also affects mortgages, pensions, and debt, understanding it helps you make better decisions about saving and spending.

• Savings: If your savings account pays 3% interest and inflation is also 3%, your money isn’t actually growing in real terms, it’s just keeping pace. If inflation is higher than your interest rate, your savings are losing purchasing power even if the balance is going up.
• Wages: A 2% pay rise when inflation is 5% is effectively a pay cut. Your salary needs to at least match inflation to maintain your standard of living.
• Debt: Inflation actually helps debtors in one sense, the real value of what you owe falls over time, because you’re repaying with money that’s worth slightly less.
• Pensions: The State Pension rises each year by the highest of inflation, average earnings growth, or 2.5%, this is called the ‘triple lock’.

Why does the Bank of England target 2% inflation?

The Bank of England has a government-set target to keep CPI inflation at 2%. A stable, low rate of inflation supports economic confidence and protects the value of savings and wages. When inflation strays too far from 2%, in either direction, the Bank adjusts the base rate to bring it back on track:

• Inflation above 2%? Raise rates. More expensive borrowing slows spending and reduces upward pressure on prices.
• Inflation below 2%? Cut rates. Cheaper borrowing encourages spending, which pushes prices back up.

If inflation goes above 3% or falls below 1%, the Bank Governor must write an open letter to the Chancellor explaining why.

Frequently asked questions

What is the difference between CPI and RPI?

CPI (Consumer Prices Index) is the UK government's preferred measure and is used for the Bank of England's inflation target. RPI (Retail Prices Index) is an older measure that includes mortgage interest payments and tends to run higher than CPI. RPI is no longer classified as a national statistic but is still used for some index-linked gilts and certain regulated price rises such as rail fares.

How is inflation measured in the UK?

The Office for National Statistics (ONS) measures CPI by tracking the price changes of around 700 goods and services in a representative "basket" that reflects typical household spending. Prices are collected monthly from thousands of outlets. The percentage change in the overall index compared with the same month a year earlier is the headline inflation rate.

How does inflation affect my savings?

If the interest rate on your savings is lower than inflation, the real value of your money falls over time, it buys less even though the pound amount stays the same. For example, £10,000 earning 3% interest during a period of 5% inflation loses purchasing power each year. Keeping savings in accounts with rates that at least match inflation helps preserve their real value.

What causes inflation?

Inflation can be caused by demand-pull factors (too much spending chasing too few goods), cost-push factors (rising input costs such as energy or wages passing through to prices), or changes in the money supply. In practice, inflation episodes often involve a combination of causes, for example, supply chain disruptions raising costs at the same time as strong consumer demand.

What is the Bank of England's inflation target?

The Bank of England has a 2% CPI inflation target, set by the government. The Monetary Policy Committee uses the base rate as its primary tool to keep inflation close to this level. If inflation moves more than 1 percentage point above or below target, the Governor must write an open letter to the Chancellor explaining why and what action is being taken.