What’s inflation?

10 min read

Inflation has been around for a long time, but the last time it was in the news in such a major way in the UK was in the 1970s. The highest inflation rate ever recorded in the UK was 24.2% in 1974. You’re probably wondering why you should care about inflation now. Read on to learn what inflation is and what it means for you. 

What does inflation actually mean?

Inflation means that money loses its value over time. 

Put simply, inflation is an increase in the prices of goods and services in an economy over a period of time – it’s often reported year on year. As the prices of goods and services rise, the purchasing power of a unit of money goes down, because that same unit of money buys less than it did before. 

For example, if in July 2021 a pair of shoes cost £100 and you had £100 in the bank, you would be able to buy that pair of shoes. If inflation was 10% year on year, then in July 2022 the price of that pair of shoes would increase to £110. Our £100 won’t increase in the same way, so would no longer be enough to buy them.  You would need to find an extra £10 in order to be able to buy them. 

Another way to look at it is that the value of your £100 decreased by 10% year on year, so that £100 pounds is only worth £90 in July 2022. This is why people say that if your salary doesn’t increase in line with inflation, it’s the equivalent of taking a pay cut. 

In this example, if your salary didn’t increase by 10% between July 2021 and July 2022, your current salary would be worth 10% less now because it doesn’t have the same purchasing power – it can’t buy exactly the same items – as it did one year ago. This directly impacts the cost of living for everybody. 

The Office for National Statistics (ONS) checks the prices of a range of goods and services each month so the rate of inflation can be tracked over time. This number is known as the Consumer Prices Index or CPI. The ONS regularly reviews the items to make sure this ‘shopping basket of goods and services’ is representative of consumer spending patterns. 

Why is everyone talking about inflation now?

Inflation has been measured every year in the UK since 1960, and has ranged from 0.4% to 24.2% during that time. To put this into perspective, the UK Government’s yearly target for inflation is 2%. This target aims to create a healthy economy by keeping prices stable enough for businesses and people to set their prices and plan their spending, borrowing, saving and investing. 

The inflation rate has hovered around 2% for the past 20 years, but due to the Covid-19 pandemic, the war in Ukraine and the impact of Brexit, the UK is seeing inflation rates increase at an unprecedented rate in 2022. The effect of this is higher prices for consumers. This means the cost of living has gone up, which means increased money worries and financial pressure for many. 

Graph showing UK inflation rates from July 2021 to June 2022

What causes inflation?

There are a lot of factors that contribute to inflation in an economy, but three major reasons are the production costs of goods, consumer demand for goods and services, and changing interest and tax rates. 

  • Cost-pull inflation

When the production costs of goods increase but the demand for these goods remains the same, these costs are passed on to consumers in the form of higher prices. This is called cost-pull inflation.

  • Demand-pull inflation

When there is a strong demand by consumers for a product or service, the prices of these products or services can increase because the available supply of that item decreases. If people are willing to pay more for an item, this results in higher prices, and this is called demand-pull inflation. 

What’s the relationship between interest rates and inflation?

Governments and central banks can influence inflation rates by lowering or increasing tax rates and interest rates for businesses and people. This changes people’s behaviour around spending on goods and services. 

For example, if the Bank of England increases the bank rate, it becomes more expensive to borrow money on credit for loans and mortgages. So people are encouraged to save instead of spending. When the Bank of England decreases the bank rate, it becomes cheaper to borrow money on credit. So people are encouraged to take out loans and mortgages and spend money instead of saving. 

When interest rates are high, the repayments on credit cards and mortgages can increase if you are on a variable rate for these. This is because variable-rate mortgages and variable-rate credit cards don’t have a fixed interest rate, so the amount that needs to be repaid monthly can change. If the rates increase, you need to repay more each month. Fixed-rate credit cards and fixed-rate mortgages fix the interest rates for repayments for the length of the contract. These rates remain the same regardless of whether the Bank of England increases or decreases the bank rate during this time. 

The UK Government can reduce inflation by increasing income tax rates and/or by lowering government spending on things like infrastructure, healthcare, education, welfare benefits and defence. 

Why is inflation so high in 2022?

The current high rate of inflation in the UK is due to businesses struggling to meet consumer demand because of the supply chain issues caused by the Covid-19 pandemic. 

Energy prices have increased steeply since Russia’s invasion of Ukraine, an impact already felt by many. As Ukraine is also the world’s fourth biggest producer of grain, the war in Ukraine has caused an increase in food prices as exports have been affected. 

What does the Bank of England have to do with all of this?

The Bank of England oversees the overall financial health of the UK economy, and makes sure that the UK’s financial system is stable enough for businesses to thrive and people to have a good quality of life. One of the Bank of England’s main goals is to keep inflation low and stable, so that people can plan their spending, borrowing and investing. 

They do this by using certain strategies to keep inflation in the UK economy stable. The main way they achieve this is by changing the Bank Rate, which is the base rate set by the Bank of England, which then influences the interest rates charged by banks. Interest is the price you pay to borrow a sum of money or the amount you receive for saving money. So when the Bank of England changes the interest rate this can affect your mortgage, loan and credit card repayments, as well as the interest the bank will pay you on any money you have in a savings account. 

Interest rates are shown as percentages over one year. For example, if the interest rate set by your bank is 1%, if you have £100 in your savings account at the start of the year and leave it there for 12 months, at the end of that year you will have £101 in your account. 

Lowering interest rates usually increases spending, while increasing interest rates tends to decrease spending and encourage saving, which generally drives inflation down. 

When the rate of inflation goes below or above the target rate by more than 1%, the Governor of the Bank of England must inform the UK Government in an official letter. These open letters are published and the public can also read them. 

Will inflation come back down to 2%?

Inflation rates have been soaring in 2022, with an increase each month. In June 2022, the annual inflation rate increased to 9.4%, which is the highest rate of inflation seen in the UK since 1982. 

The Bank of England has been taking steps to bring down inflation in 2022, including raising interest rates. In August 2022, the Bank of England raised the bank rate to 1.75%, the biggest increase for 27 years. 

In its latest forecasts, the Bank of England has predicted that inflation will reach 13.3% in the winter of 2022 due to rising energy costs, and that navigating the cost of living will remain difficult throughout 2023 and ease up in 2024. 

The Bank of England is committed to bringing inflation back down to its target of 2%.

Glossary of terms

Words you might hear in relation to inflation.

Bank of England – the UK’s central bank.

Bank Rate – this is the rate set by the Bank of England that determines the interest they pay to commercial banks that hold money with them. 

Consumer Price Index (CPI) – way of measuring the change in prices for consumers from month to month.

Cost of living – the amount of money needed to pay for basic living expenses.

Currency – the system of money used in a country.

Deflation – a decrease in the prices of goods and services; money increases in value over time.

Economy – the trade and industry that creates the wealth of a country.

Inflation – an increase in the prices of goods and services; money loses value over time.

Monetary Policy Committee – this committee forms part of the Bank of England, and is made up of nine members: the Governor of the Bank of England, three Deputy Governors for Monetary Policy, Financial Stability and Markets and Banking, the Bank of England’s Chief Economist and four external members who are appointed by the Chancellor of the Exchequer for their expertise in economics and monetary policy. They meet approximately every six weeks to discuss whether to increase, decrease or leave the base rate of interest as it is. 

Office for National Statistics – independent institute which produces official statistics for the UK.

Pound Sterling – the official currency of the UK. 

Purchasing power – how much of goods or services that one unit of currency can buy.

Recession – when there is a decrease in economic activity, and the economy of a country contracts over a period of time.

Shrinkflation – items getting smaller in size or quantity while the price remains the same or increases.

Stagflation – slow growth, high unemployment and rising prices in an economy.

Further Chapters

What’s inflation?