With the UK’s unstable inflation rates in the last few years, you may be wondering how does inflation work and what does it mean for me? Learn what influences inflation and the steps you can take to keep on top of things financially.
Inflation is used to measure the change in prices of goods and services over time. If inflation is increasing, prices for everyday items such as food will also increase. This means everything from housing to transportation will also have a higher price.
Each year, some inflation is expected within a country’s economy. The Bank of England inflation target is set at 2%. This means that prices and wages are expected to rise by around 2% each year. If inflation becomes unstable or too high, it will be difficult for people to plan their spending, and businesses may find it challenging to set the right prices.
What causes inflation to rise?
There are three main reasons for inflation to rise in an economy.
1. Demand-pull inflation
This kind of inflation is a result of an imbalance in demand and supply. Typically, if demand for a product increases but the potential to supply remains the same (or can’t keep pace with demands) the product price is likely to rise.
Often a high demand in goods means businesses will sell to the highest bidder, driving prices up. Similarly, stresses to the supply chain can result in increased prices.
Businesses that provide in-demand goods or services may have to employ new workers to fulfill new outputs. As companies employ more workers, the cost of covering these new wages will now be reflected in an increased consumer price. This ultimately leads to an inflation increase, as higher demand has driven prices to unexpectedly increase beyond the expected yearly level.
2. Cost-push inflation
Cost-push inflation occurs when the cost of creating a product or service goes up, while the demand stays the same. To maintain profits, businesses pass on the cost to buyers.
For example, if the demand for goods remains the same while wages or raw materials go up, it can lead to cost-push inflation. Higher production costs usually slow down the overall production of goods or provision of services.
As there is now a smaller supply of goods or services while the demand for them remains high, the price increase is covered by the consumer. This has the effect of driving inflation higher.
Cost-push inflation can be contrasted with demand-pull inflation, as inflation is driven by higher costs in the supply chain rather than higher demand.
3. Inflation expectations
Inflation expectations refer to the expectation that consumers and businesses have for future rises in costs. The expected rises in costs for consumers can also be seen as an expected average rise in wages for workers. In theory, inflation expectations are what drive prices and wages higher at a similar rate over time.
This expectation is largely based on the Bank of England’s own target of 2% inflation each year. These inflation expectations are in place to ensure a healthy economy. If inflation falls or rises suddenly, it can become difficult for businesses and consumers to gauge their expectations.
The inflation rate is described as ‘unanchored’ when it significantly shifts away from the Bank of England target. ‘Unanchored’ inflation rates may cause the economy to experience a prolonged period of higher inflation. This is because consumers and businesses adjust to expectations of higher overall costs.
What other factors affect inflation rates?
If a currency such as the Great British Pound (GBP) loses its value when compared to other currencies, such as the Euro, imports will become more expensive. The higher costs of imports mean an increase in prices for the consumer. Whether it’s energy, raw materials, or food, currency devaluation will mean it costs more to purchase these commodities. This reduction in purchasing power drives inflation as the value of your money has effectively decreased.
Government fiscal policy
Fiscal policy is how a government uses taxation and spending to influence the economy. In the UK, the Chancellor of the Exchequer is responsible for drafting and presenting the fiscal policy during the annual budget. If fiscal policy reduces tax rates, then businesses may choose to hire new workers and improve shops or warehouses. Lower taxes may also mean that consumers purchase more. This is often done with the intention of stimulating an economy with lower-than-expected inflation by increasing demand for goods and driving demand-pull inflation.
Rising wages contribute to cost-push inflation. When workers earn more, the goods produced or services offered will also cost more, so that businesses can still maintain profits. However, economists must track the relationship between wages and consumer prices closely.
If the relationship between wages and prices goes untracked, this could result in a wage-price inflation spiral. This term is used to describe the event of constant price rises followed by continual increases in wages. According to some, this would perpetually drive inflation higher. The government can attempt to stop a wage-price spiral by requesting that the Bank of England increases interest rates to discourage spending.
How is inflation measured?
In the UK, the main measure of inflation is the Consumer Prices Index (CPI). The percentage inflation is determined by analyzing around 700 goods and services each month. These goods and services are selected from around 150 outlets around the UK and chosen at random.
The Office for National Statistics (ONS) uses these prices and compares them with the same average prices from a year ago. These price changes determine the CPI, and the ONS publishes its findings each month.
If the average price increase of the goods and services analyzed has gone up by 3% when compared with the same time last year, then the inflation rate is understood to be 3%.
The ONS also publishes the Consumer Prices Index including owner occupiers' housing costs (CPIH). In addition to the goods and services analyzed for the CPI, the CPIH includes any costs relating to ownership, maintenance, and living in your home. This statistic also includes council tax. The CPIH is considered the most in-depth measure of inflation as it reflects both living costs and costs of general day-to-day goods and services.
Why has inflation been rising in the UK?
From around mid-2021, the UK’s inflation rate rose above the 2% target. One of the main reasons for a sudden inflation increase was the higher demand for consumer goods around the world. Following the major lockdown restrictions of the Covid-19 pandemic, consumers were spending more while the supply of goods was lower than usual. This is an example of demand-pull inflation.
As of 1st January 2021, the UK left the European single market. The single market was a trade agreement between the UK and other EU countries which enabled free movement of goods, services, and people between EU countries. Following the UK’s departure from the Single Market, exports and imports to EU countries fell significantly. This imbalance of supply and demand saw prices increase and pushed up inflation.
Another contributor to higher inflation were rapidly increasing energy and fuel prices. As gas and oil were in greater demand after the Covid-19 pandemic, prices quickly rose. Russia’s invasion of Ukraine added to the increase of energy prices as much of Europe relies on gas and oil from Russia.
Overall, the increased demand for food, services, and energy has pushed prices up across the board. As wages have generally increased in response to higher prices, inflation remains high in the UK after reaching a 41-year high of 11.1% in October 2022.
Since then, the inflation rate has been steadily decreasing, though interest rates remain high in order to avoid prolonging the inflation.
How to keep your finances in check during periods of unexpected inflation
Inflation can be unpredictable, so it’s a good idea to protect your savings from the rise in prices. While ‘beating’ inflation is often unlikely, there are a few ways to help reduce the impact of rising prices.
Establish a long-term savings account
A fixed rate bond is a type of long-term savings account. With this type of savings account, you can save your money and get a fixed interest rate for an agreed period of time. This could be after one or five years. So long as you don’t withdraw your money early, you’ll benefit from a better interest rate when compared to other types of savings accounts. Remember though – the interest rates may be tempting, but there will be a penalty charge if you need to withdraw your savings before the agreed period is over.
Shop around for competitive interest rates
In times of financial instability, you may find it helpful to shop around for the best deal. For example, you may be remortgaging your house after a fixed-rate mortgage is coming to an end. You may also be looking to release some equity to improve your home. Keep your monthly repayments manageable and ensure you get the best interest rates by using our remortgage calculator.
An increasing number of people are making investments in the stock market. It can be a clever way to beat inflation if the money you put in has higher returns than the inflation rate. But it can be very risky – you could lose your entire invested funds.
Sign up for rewards schemes
Be a savvy shopper and sign up for rewards schemes for various supermarkets and shops. You could access better deals or earn points which may help reduce your food shop bills over time.
Looking for more ways to help keep on top of your finances? Browse our Know How blogs and learn more about how to make finance work for you.