What is inflation and how does it affect you?

Inflation has now hit the Bank of England's target. But what is it - and how does it affect your personal finances?

What is inflation symbolised by a woman choosing fruit in a supermarket
Inflation dropped to 2% in May 2024
(Image credit: © Richard Baker / In Pictures via Getty Images)

Inflation has fallen to its lowest level in almost three years - but what is it and how does it affect you?

The Office for National Statistics (ONS) calculated that the rate for May, the most recent month for which we have data, was 2% - a 0.3 percentage point drop on April's figure that means it's now on the Bank of England's target. It is also significantly below the peak we saw in October 2022, when the rate hit 11.1%.

The latest figures have come partly as a result of the highest interest rates the UK has seen for 16 years. But they are also thanks to how inflation is calculated, with the country's headline rate being the Consumer Prices Index (CPI).

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So, what is inflation - and how does it affect you? Here's what you need to know.

What is inflation?

Inflation is a measure of how quickly prices are rising over a given time period. Put simply, if you spent £1 on a product this time last year and inflation now stands at 10%, that same product is likely to now cost £1.10.

So, it's a useful way of measuring how our spending power has changed over time. But it also has a real-world impact. For example, inflation rates are used to set the amount some key utility bills go up by, as well as how much people can get from the state pension.

Economists believe having some inflation (2% is the golden percentage in the UK) is healthy for the economy because it encourages spending and means GDP can grow. But having too much or too little can weaken the economy, while soaring inflation can do severe damage to living standards (as we've seen during the cost of living crisis). Deflation, i.e. the rate of decreases in prices, is seen as being even worse than inflation.

Every month, the Office for National Statistics checks the prices of hundreds of goods and services in an imaginary shopping basket. This is meant to represent the sorts of things that the average British consumer buys - although it is by no means a perfect science.

It includes supermarket basics like bread, milk and fruit, as well as electrical products, clothes, energy bills, flights, train tickets and accommodation. It also gets updated every year to reflect changes in UK spending habits.

Inflation is expressed as several different indices, but the most widely reported is the Consumer Prices Index (CPI). The CPI is an internationally-recognised measure of inflation.

It strips out housing costs like council tax and mortgage payments. Other indices include the Retail Prices Index (RPI) and Consumer Prices Index including owner occupiers' housing costs (CPIH).

Data within the CPI data, such as core inflation and services price hike figures, are also used by economists to determine how embedded inflation is in the wider economy. These figures tend to be looked at by the Bank of England when it sets interest rates.

Will inflation continue to fall this year?

The Bank of England says its first priority is to keep inflation at 2%. Forecasters expect inflation could fall rapidly this year. The Oxford Economics consultancy and analysts at Investec and Deutsche Bank have predicted that CPI will drop below 2%, but ING Group reckons it could rise again slightly to 2.5% later this year.

In its report accompanying the Spring Budget, the Office for Budget Responsibility (OBR) said inflation had “receded more quickly” than expected since its Autumn Statement calculations. It says its central forecast now has CPI inflation dropping to an average of 2.2% over the course of 2024, and 1.5% over the duration of 2025, before it climbs back towards the Bank of England’s 2% target.

However, the OBR also highlighted the risk of an escalation in the Middle East in its forecasts. Although it expects the Red Sea crisis to cause a small 0.2 percentage point upward movement in inflation, a wider conflict could see the headline rate climb back towards 6%. This would be mostly due to an expected surge in wholesale energy prices.

Another fly in the ointment is wage growth. While pay rises are a good thing for our wallets, the Bank of England fears they can fuel inflation as they may boost people's spending power. According to the most recent official wage growth data, salaries are still rising rapidly.

The Bank of England has itself said that inflation could drop to 2% in the spring “for a short while”, though is likely to increase after that. It has repeatedly raised interest rates over the past 18 months to try and tackle stubbornly high inflation. The base rate is now at 5.25% - a 16-year high - and may stay at this rate for a bit longer due to the general election and the stickiness of some aspects of inflation, like the rate of services price hikes.

How does inflation affect you?

Inflation affects different people in different ways, and some people will have a higher rate of personal inflation than others depending on their wealth. For example, a 75-year-old person reliant on the state pension is likely to spend a greater proportion of their income on heating and food compared to a 40-year-old high flyer on a City income.

But no matter who you are, price hikes will affect your budget, and may potentially reduce the number of things you can afford.

Inflation is also used by the government and businesses to set prices. Things like train fares and broadband go up in price every year depending on the inflation rate, so that - in theory at least - they don't lose out from the erosion of the value of the pound.

This can also work to your advantage. It's worth bearing the rate of inflation in mind when considering asking for a pay-rise, or if you're a landlord and want to increase rents.

If you want to ensure the value of your money keeps up with - or at least stays close to - inflation, we've listed the inflation-busting savings accounts currently on offer. However, you may need to be quick as banks and building societies could soon start to further reduce their rates in anticipation of a Bank rate cut later this year.

Check out our round-up of the best easy-access accounts, one-year savings bonds, regular saver accounts and cash ISAs.

When is inflation data released?

The ONS reveals the latest inflation figures each month. Each release details the latest inflation rate for the previous monthly period.

The first three readings of the year (covering January, February and March) were released on 14 February, 20 March and 17 April. The figures for April appeared on 22 May, while the reading for May was published on 19 June.

We will get the next ONS release on 17 July. The final inflation reading for 2024 (covering December) will be released early in the new year on 15 January 2025.

Ruth Emery
Contributing editor

Ruth is an award-winning financial journalist with more than 15 years' experience of working on national newspapers, websites and specialist magazines.

She is passionate about helping people feel more confident about their finances. She was previously editor of Times Money Mentor, and prior to that was deputy Money editor at The Sunday Times. 

A multi-award winning journalist, Ruth started her career on a pensions magazine at the FT Group, and has also worked at Money Observer and Money Advice Service. 

Outside of work, she is a mum to two young children, while also serving as a magistrate and an NHS volunteer.

With contributions from