Inflation is a key economic metric that affects the cost of living, interest rates and determines the value of your money.
In simple terms, inflation measures how much the price of goods and services is rising over a set period of time.
The Office for National Statistics (ONS) tracks inflation across different baskets of goods – the main one is the Consumer Prices Index (CPI).
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Inflation means people are paying more now than they were before for the same product or service, eroding the real-terms value of their money. Higher inflation means that prices are increasing at a faster rate; lower (but still above zero) inflation means that prices are rising at a slower rate.
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Rising inflation doesn’t just mean higher prices of everyday goods. It can impact the mortgage and savings market too.
What is inflation and why is it important?
Inflation is a measure of how much prices have risen over a given time period. If you bought an orange for £1 in one year, but bought the same orange for £1.10 the next year, its price will have inflated by 10%.
That said, the rise in price of one item doesn’t reflect how much prices are increasing across an entire economy.
The orange’s price may have increased at a much faster rate than other services or products. For example, a poor harvest leading to fewer oranges than usual could prompt a price rise due to the laws of supply and demand.
Furthermore, different people buy different things. You might be more likely to buy a packet of sweets than an orange, meaning you are less affected by the rising price of an orange.
When the ONS tracks inflation, it looks at a broad, representative basket of goods and services rather than just one item.
This basket could include price rises of food, energy, clothes, hotels, train tickets and more.
The ONS shakes up its basket of goods once per year to accurately reflect consumer trends, giving it a more holistic view of how prices are changing across the entire economy.
Once the ONS has gathered all the prices, it calculates the level of inflation in the economy and expresses it through several different indices. The most widely reported is CPI, which is the most internationally-comparable index.
CPI strips out housing costs like council tax and rent payments. Other indices include these, such as the Retail Prices Index (RPI) and the Consumer Prices Index including Owner Occupiers' Housing Costs (CPIH).
Inflation rates are used to set the amount by which rail fares, some key utility bills and even interest rates on student loans go up. The figure is also sometimes used to determine how much the state pension will rise by, under the triple lock mechanism.
Economists believe having some inflation (for example the BoE’s 2% target) is healthy for the economy because it encourages spending and means GDP can grow.
However, high inflation can damage living standards, as we saw during the cost of living crisis.
Why will there be inflation in an economy?
There are many reasons why prices rise in an economy.
Food prices can be pushed higher because of natural causes, like bad weather, which can affect crop yields and lead to product shortages.
Prices can also be artificially inflated through government actions. In the United States last year, prices of some foreign goods increased after Donald Trump imposed a sweeping set of tariffs (taxes paid to the government when importing goods).
On the whole, there are two main types of inflation – ‘cost-push’ and ‘demand pull’.
- Cost-push inflation: This type of inflation is caused by an increase in production costs. Imagine cocoa prices rise. This might make it more expensive for a chocolate company to produce chocolate bars. In response, the company can either produce fewer bars or put up its prices. In recent years, companies have circumvented higher production costs by shrinking the size of products but keeping the price the same, known as ‘shrinkflation’.
- Demand-pull inflation: This type of inflation happens when demand outstrips supply. A good example is what happened after the Covid lockdowns ended. Households had saved up a lot of money while they were cooped up, and splurged after the economy opened back up.
Inflation expectations can also create price pressures.
If workers think what they will pay for products will rise, they might negotiate larger pay rises from their employers. This pushes up costs for businesses by giving them a higher wage bill.
It also gives workers more money in their pocket, making them more likely to spend. Both effects can worsen the inflation cycle.
How does inflation affect you?
Inflation affects different individuals and groups to different extents. Some people will have a much higher personal inflation rate than others depending on the types of things they spend money on.
For example, someone who travels to and from work every day by car is more likely to be stung by rising fuel prices than someone who commutes.
Inflation is used by the government and businesses to set prices and make sure revenues do not fall in real terms.
For example, train fares have historically gone up in price every year depending on July's inflation rate, though the government has frozen fares in 2026 for the first time in 30 years.
Fare hikes theoretically mean services like the railways don't lose out from the erosion of the value of the pound.
Inflation can work to your advantage. It's worth bearing the rate of inflation in mind when asking for a pay rise, or if you are a landlord and want to increase rents.
When it comes to your personal finances, you need to make sure the spending power of your money keeps up with or ideally exceeds inflation. To achieve this, you will need to put excess cash into an inflation-busting savings account.
See our list of the best easy-access accounts, one-year savings bonds, regular saver accounts and cash ISAs.
Once you have built up sufficient cash savings, you may also want to start investing, provided you are willing to lock the money away for at least five years to ride out short-term market volatility. Investing in a diversified portfolio of assets can be a good strategy for beating inflation.
What is the Bank of England's role in controlling inflation?
The Bank of England, the UK’s central bank, plays a key role in keeping inflation in check. The main way it does this is through adjusting the “bank rate”.
The bank rate is the rate of interest the BoE pays to commercial banks, building societies and other financial institutions that hold money with it. It is also the rate the BoE charges on loans to them.
The bank rate is also known as the base rate. Because changing the bank rate impacts other interest-paying assets it is often colloquially referred to as ‘interest rates’.
A hike in interest rates can incentivise saving and increase the cost of borrowing, which is a disinflationary pressure. Cutting interest rates makes borrowing cheaper and reduces the returns on savings, encouraging more spending and therefore higher inflation.
The BoE can also stimulate inflation through quantitative easing (QE), when it can’t lower the bank rate anymore. QE was most famously used in the UK during the 2008 financial crisis.
This process involves buying bonds to push up their price. This leads to interest rates falling, encouraging people to spend money.
The BoE can also sell bonds through quantitative tightening (QT), to reduce money supply in the economy and slow inflation.
What is the difference between disinflation and deflation?
Disinflation and deflation are two different things, and understanding the difference between them is important.
Disinflation is when the rate of inflation slows but prices are still rising, just at a slower pace than previously.
For example, if inflation one month reads 3.4% then drops down to 3% the following month, there has been disinflation of 0.4 percentage points.
Deflation, sometimes known as negative inflation, refers to when the rate of inflation falls below zero, meaning prices are falling. Economists believe deflation is worse than inflation as it can lead to consumers holding off from spending in the hopes the price of something will fall in the future, causing an economy to slow.
Deflation can also make debts more challenging to pay off, as the real value of the debt goes up.
Deflation can spiral into recession and higher unemployment rates as companies lay off staff, which reduces the amount of money in the economy even more and exacerbates deflation.
Stagflation, meanwhile, is another thorny economic problem where high inflation coincides with weak economic growth. This is difficult for policymakers to address, as higher interest rates (which counter inflation) tend to damage economic growth, so hiking rates is a risky move in a stagflationary environment.
