It’s a term we’ve all heard before, but how many of us really know what inflation means and how it affects our money?
Here we explain what inflation is, what causes it and the impact it can have on your money’s spending power.
What is inflation?
Most definitions for inflation will say something along the lines of the decline in purchasing power over time. In other words, inflation is the steady and sustained increase in the prices of the goods and services we buy. So far, so simple, but what does this actually mean and how does it happen?
A simple way to understand what inflation really means is to compare the price of an everyday item today to its price last year. So for example, a loaf of white bread that cost £1 this time last year might have risen in price to £1.02, which effectively means it has an inflation rate of 2%. Of course, inflation doesn’t only impact food prices, but the cost of everything we buy, from the price of a train ticket to a new t-shirt.
What is the current inflation rate?
Inflation, which is measured by the Consumer Prices Index (CPI), fell to 1.7% in the year to September 2024, dipping below the government’s long-term inflation target for the first time since 2021.
Meanwhile, the Retail Prices Index (RPI) measure of inflation, which includes housing costs, eased to 2.7% in the 12 months to September, down from 3.5% in August.
What causes inflation?
So what causes prices to rise more sharply sometimes and then for these increases to slow at other times? There are a huge number of factors that drive inflation, and it can seem a little complicated, as many of these reasons are interlinked, but broadly speaking, inflation tends to rise more sharply when:
Business costs rise – known in the economic world as ‘Cost push’ inflation, this is where the cost of doing business goes up and this increase is passed on to the consumer. The cause of the rise in costs could be for a wide array of reasons, including:
Raw materials have become more expensive – If an item has become less readily available, or the country the item is being exported from is becoming more developed, they may charge more for their materials.
Workers demanding more money for their work – This can happen if a group of employees has organised themselves to demand higher wages, or where there is more demand for certain roles than there are people to fill them. We are currently seeing this in the UK with a shortage of HGV drivers, which has seen an increase in salary offers and packages to attract more people into the roles.
Increase in property prices – As the demand for appropriate working locations goes up, so do the prices businesses have to pay to get them.
There is greater demand for goods and services than there is supply – also known as ‘Demand’ inflation, as the demand for a certain item or service goes up, so does the price, as the amount of that item or service that is available is limited. Governments are able to stimulate this situation by offering tax breaks or reducing the amount of tax you pay, which means people have more disposable income and can inject more money into the economy, but as people have more money to spend, prices will also tend to increase, creating demand inflation.
The exchange rate changes – Much of the UK economy is based on imports and exports of goods to other countries, so when the pound weakens against other currencies, we will have to spend more to buy the same things as before.
- More money is created electronically – When the economy is in need of support, as it was during the pandemic, the Bank of England can pump money into it via a process known as quantitative easing. This essentially involves creating new money electronically which is then used to purchase government bonds. This pushes up the price of bonds, which in turn means that the bond yield, or ‘interest rate’ that holders of these bonds get, goes down. Lower interest rates on bonds affect rates on loans for businesses, which become cheaper. This helps boost spending and pushes up inflation.
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Is inflation a bad thing?
The type of low-level inflation we generally experience in the UK is not a problem in itself and as long as all areas of life keep up with inflation, such as wages, there is little issue. The reality is however, not all areas of life do keep up with inflation, and as a result, when prices rise sharply, as they are now, but wages don’t, people will have to sacrifice their way of living to accommodate their new budget.
The Bank of England is tasked with keeping inflation at a target rate of 2%. Expectations are that it should hopefully remain at this level or at least close to it for a while, although we may see an uptick next month following the increase in October’s energy price cap.
Sticking to a target aims to prevent the type of hyperinflation that we have historically seen in places like 1920s Germany, Zimbabwe in 2008, or Venezuela which started in earnest in 2016 and is still ongoing. These instances of hyperinflation have seen inflation rates of incomprehensible percentages, for example, Zimbabwe saw an annual inflation rate of 89.7 sextillion (89,700,000,000,000,000,000,000%) which essentially meant that prices were doubling every 24.7 hours. The highest inflation rate in the UK was 24.2% in 1975. Although inflation is a long way off this figure, it is still extremely high and placing a huge strain on people’s finances. Find out about some of the different ways you might be able to reduce your outgoings in our article How to save money – 21 best money saving tips.
How is inflation monitored and controlled?
The Bank of England is the UK’s central bank which essentially means that it is in charge of managing the UK’s currency and monetary policies. It also oversees the commercial banking system.
As the UK’s central bank, it’s the Bank of England’s role to continually track inflation and try to maintain an inflation rate of around 2%. They can help to control inflation rates by changing the base rate (also known as Bank Rate), which is the most important interest rate in the UK, as it is the rate they pay to all commercial banks that hold money with them, and therefore the rates that those banks charge people or pay on their savings. Currently, the base rate is at 4.75%.
If the Bank of England increases the base rate, which then increases interest rates across the financial market, it should help dampen inflation as borrowing becomes more expensive, slowing down spending and encouraging saving. If it lowers the base rate, the opposite happens, making spending a better option, and people will be more likely to take out loans and mortgages at this time as borrowing costs are lower.
While the Bank of England aims to help to control inflation, it’s the Office for National Statistics that actively monitors the inflation rate. To do this, it gathers prices of a set list of generic items which are meant to represent a range of items that any consumer may frequently buy. The list changes every year to align with changes in consumer taste. An example of this could be the inclusion of a new type of food such as quinoa if there has been a trend in people buying it across the country.
It is a statistic that is tracked by a number of different measures which include:
- Consumer Price Index (CPI) – This measure of inflation tracks a list of items that represent the average shopping basket of goods and services in the UK and how their prices change over time. It is regularly updated to reflect the public’s changing preferences and shopping habits.
- Retail Price Index (RPI) – The Retail Prices Index also tracks a basket of goods and services, but includes mortgage interest payments too, whereas CPI does not.
How might rising inflation affect my savings and investments and my pension?
Savings
When inflation rises sharply, interest rates will usually rise to dampen spending. If you have savings, this is good news for you, as higher interest rates will usually mean better returns. The reverse is also true, so when inflation eases, interest rates are likely to fall, which in turn will lead to lower savings rates. The Bank of England reduced the base rate to 4.75% in November 2024, but there are still plenty of savings accounts offering attractive inflation-beating returns, especially now inflation has dropped to its lowest level in more than three years.
Read our article Five ways to boost your savings returns to explore some of the ways you might be able to make your savings work harder for you.
Pensions
A key area where high inflation can really affect people is through the erosion of the value of pension savings. While a lot of people’s savings are transitory, as they are often saving for a big purchase or life event, pension funds are a lifetime investment, and if a large proportion of your retirement savings is sitting in cash earning below-inflation interest rates, you could struggle to make ends meet when you retire. It’s essential to keep a close eye on how the funds your pension is invested in are performing, and if they aren’t providing the returns you think they should be, it may be worth exploring other investment options. For more information on this, have a look at our articles How does inflation affect my pension? and Where is my pension invested?
If you want personal recommendations about where to invest your retirement savings, you’ll need to seek professional financial advice. You can find a local financial advisor on VouchedFor or Unbiased, or for more information, check out our guides on How to find the right financial advisor for you or How to get advice on your pension.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
Investments
The impact that inflation has on your investments will depend on the type of assets you hold, such as bonds, stocks and shares or property. There are certain investments that have in recent decades tended to beat inflation rates, with the main one being property, although of course past performance should not be relied on as an indicator of what will happen in the future. Average UK property prices reached £293,000 in August 2024, according to latest UK Land Registry data, an annual increase of 2.8%.
Shares can potentially protect investors from inflation as the companies you invest in are often able to increase their prices in response to higher costs, which means they can then in theory grow at the same rate or higher than inflation. This won’t always be the case, however, and there are significant risks involved which could mean you end up with less than you put in. If you’re not sure where to invest, or whether investing is right for you, it’s a good idea to seek professional financial advice. Find out more in our guide Is investing right for you?
You can find a local financial advisor on VouchedFor or Unbiased, or for more information, check out our guide on How to find the right financial advisor for you.
How might inflation affect my mortgage or loans?
If you already have a mortgage or a loan and are on a fixed rate, then it’s unlikely you will be affected by inflation, but when the time comes to remortgage if inflation remains low and the base rate has reduced, you should have a wider choice of competitive mortgage deals to choose from.
The people who are usually hardest hit when inflation is high are those whose fixed interest period has ended on their mortgage and have moved onto a standard variable rate, or those with a tracker mortgage, which tracks movements in the Bank of England base rate. Both of these are likely to end up with higher interest rates to pay when inflation is steep. If you are on your lender’s standard variable rate, you will usually be free to remortgage and should be able to find a much cheaper deal. Learn more in our guide Five good reasons to remortgage right now.
Want to speak to a mortgage advisor? Speaking to an experienced mortgage advisor can help you to understand your options and get a great deal on your mortgage.
If you’re looking for expert mortgage advice, you can get a free consultation with an independent mortgage adviser at Fidelius. Speak with a qualified, FCA-regulated, independent mortgage adviser you can trust. Rated 4.7/5 on VouchedFor from over 1,250 reviews.
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