What is inflation and how does it affect you?

Inflation is one of the key economic metrics often mentioned by the government and the Bank of England.

Inflation measures how much prices across different sectors of the economy have risen – from supermarket shops to the cost of jetting off on holiday.

Like most central banks, the Bank of England targets a 2% rate of inflation. This is viewed as optimal for a healthy economy by most economists.

MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

But for quite some time now, inflation has been higher than the central bank’s target.

In recent times, the UK first started to experience high inflation at the start of the cost of living crisis, when inflation quickly climbed from 2% in July 2021 to a peak of 11.1% in October 2022.

After falling from that peak and returning to the Bank of England’s 2% target in 2024, inflation has risen again to stubbornly-high levels in recent months.

The latest data shows that inflation was 3.8% in July, August, and September 2025, the highest it has been for 18 months.

“Stubborn inflation is worrying for consumers,” said Alice Haine, personal finance analyst at investment platform Bestinvest. She points out that even though the annual inflation rate held steady in September, prices were “still very much on the rise”. Three consecutive readings of 3.8% simply means prices increased at the same rate as in July.

“Add to that the extended freeze on income tax thresholds, where more people find themselves dragged into higher tax brackets as their wages rise, and household budgets will continue to feel stretched,” she said.

Most economists think September’s reading is the highest inflation will be this year, and expect a gradual return to 2% throughout 2026 and the start of 2027.

We take a closer look at what inflation is, how it is measured, and what it means for your finances.

What is inflation?

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

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 by which rail fares and some key utility bills go up. The figure also plays a role when determining how much the state pension will increase by.

Economists believe having some inflation (for example the Bank of England's 2% target) is healthy for the economy because it encourages spending and means GDP can grow. However, soaring inflation can do severe damage to living standards, as we've seen during the cost of living crisis.

Types of inflation

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 other words, the price of chocolate bars is pushed up by higher cocoa prices.
• 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 used their newfound freedom as an opportunity to splurge. The surge in demand pulled prices up.

Inflation expectations can also create price pressures.

If workers think prices are going to rise rapidly, 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 worsen the inflation cycle.

How is inflation calculated?

Every month, the Office for National Statistics (ONS) 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.

The ONS updates the inflation basket every year to reflect changes in UK spending habits. Some new additions for 2025 include VR headsets and yoga mats, while oven-ready gammon joints and newspaper adverts have been removed.

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

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).

Data within the CPI report, such as core and services inflation, is 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.

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 lifestyle.

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 of London salary. 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 go up in price every year depending on the inflation rate so that, in theory at least, those services don't lose out from the erosion of the value of the pound.

It 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.

In your own personal finances, you will want to ensure the value of your money keeps up with or at least stays close to inflation. To achieve this, it is important to pick an inflation-busting savings account.

Check out our round-up 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 consider 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.

Data from Barclays looking back over the past 120 years or so shows that equities have outperformed cash 70% of the time, based on a two-year holding period. If you extend the holding period to 10 years, it rises to 91% of the time.

We take a closer look at this topic in our beginner’s guide to investing, and in our piece on saving versus investing.

When is inflation data released?

The ONS reveals the latest inflation figures each month. Each release details the inflation rate for the previous monthly period. The data is released at 7am.

The next set of inflation data, covering October, is due to be released on 19 November. For a full list of upcoming reports, see our calendar of CPI release dates.

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 the process that takes place when the rate of inflation falls. In a disinflationary environment, prices are still rising, but at a slower rate than they once were. For example, inflation hit 11.1% at the peak of the cost-of-living crisis, compared to 3.8% today. Prices are rising in both environments, but the rate of price increases is lower today.

Meanwhile, deflation refers to when prices fall over time. As enticing as deflation sounds, it is often regarded by economists as worse than inflation. It can result in reduced consumer spending, as people put off purchasing things in the knowledge prices could be lower next week, next month or next year.

This can cause the economy to slow, potentially resulting in recession and higher unemployment rates as companies lay off staff. Deflation can also make debts more challenging to pay off, as the real value of the debt goes up.

What is stagflation?

In recent months, there has been a lot of talk about stagflation. Some analysts think the UK is at risk of falling into this environment. Stagflation refers to a predicament in which economic growth is stagnant while inflation is high.

The resulting economic situation becomes challenging, as high inflation means the purchasing power of money is eroded while anaemic economic growth and unemployment mean people have less cash to spend.

The UK experienced a long run of stagflation in the 1970s when inflation reached 24.5% in August 1975. At the same time, the economy was contracting – GDP fell by 2.5% in 1974 and 1.5% in 1975.

Is Britain going to enter a similar state of stagflation in the near future? The answer is that it is probably too early to tell. While some economic indicators (stubborn inflation and low GDP growth) mirror the results you would expect from an economy about to enter stagflation, the situation is still far from being as dire as it was in the 1970s.

We take a closer look in our stagflation explainer.