What is inflation and how does it affect you?

Inflation has more than halved over the past year, but remains above the Bank of England's 2% target. What is inflation and how does it affect your finances?

Woman in a supermarket
(Image credit: © Richard Baker / In Pictures via Getty Images)

Inflation has more than halved over the past year, and is at its second-lowest level since September 2001, bringing some relief to household bills.

Office for National Statistics data shows that inflation was unchanged at 4% in the 12 months to January. That was better than expected, with forecasters predicting inflation would increase off the back of higher energy bills.

Inflation has generally been on a downward trajectory in recent months, which will be welcome to households, though it’s notable that the current 4% rate remains double the the Bank of England's 2% target.

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We explain what inflation is, the outlook for inflation this year, and how it affects you.

What is inflation?

Inflation is a measure of how quickly prices are rising. In a nutshell, it answers the question of “how fast are prices in general rising compared to this time last year?”

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 roughly represent the sorts of things that the average British consumer buys.

It includes supermarket basics like bread, milk and fruit, as well as electrical products, clothes, energy bills, flights, train tickets and accommodation.

Inflation is expressed as several different indices, but the most widely reported is the Consumer Prices Index (CPI), which strips out housing costs like council tax and mortgage payments. There is also a Retail Price Index (RPI) and Consumer Prices Index including owner occupiers' housing costs (CPIH).

If prices have not risen compared to last year, and have actually fallen, the rate is called deflation. 

Will inflation continue to fall this year?

The Bank of England - and the prime minister - say they are committed to lowering inflation.

Getting it down to around 4% has already been applauded, following a year of eye-watering price rises. In October 2022, inflation hit 11.1%.

Forecasters say 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% within a few months, while ING Group goes further, expecting the rate to plunge to 1.5% in May.

The Bank of England has a target to reduce inflation to 2%, and keep it around that level. It has said that inflation could drop to 2% in the spring “for a short while”, though is likely to increase after that.

The Bank has repeatedly raised interest rates over the past 18 months to try and tackle stubbornly high inflation. Base rate is now at 5.25% - a 15-year high - and is expected to start falling this year.

How does inflation affect you?

Rising prices will affect your budget, and potentially reduce the number of things you can afford.

Inflation affects different people in different ways, and some people will have a higher rate of personal inflation than others. 

For example, a 75-year-old pensioner will have a very different shopping basket (and likely spend more of their income on heating) to a 20-year-old student (who may, perhaps, spend more on eating out and video games).

Meanwhile, inflation is used by the government to set things like train fare increases. It is also a component in the state pension triple lock. Telecoms and water firms also use a measure of inflation when up-rating the price of contracts. 

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're looking for an inflation-busting savings account, the good news is some accounts pay more than 4%. However, you will need to be quick as many banks and building societies are starting to reduce their rates in anticipation of a Bank rate cut this year. 

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

Ruth Emery

Ruth 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, a magistrate and an NHS volunteer.