What is inflation and how does it affect you?

What is inflation? Concept symbolised by a woman choosing fruit in a supermarket.

(Image credit: © Richard Baker / In Pictures via Getty Images)

By Ruth Emery

last updated 25 October 2024

Contributions from

Katie Williams

in Features

You've probably heard about inflation a lot during the cost-of-living crisis. But what is it?

It is often mentioned by the government and the Bank of England. You may also have heard of it in connection with the economy and with interest rates. The term relates to how much things cost.

In particular, it covers how much prices across all different sectors of the economy – from supermarket shops to the cost of jetting off on holiday – have risen. In September, its official rate, as measured by the Consumer Prices Index (CPI), slowed to 1.7%, dropping below the Bank of England’s 2% target for the first time in over three years.

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But what exactly does this mean and how does inflation impact your finances? We've explained everything 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.

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 rail fares and 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 Bank of England's target) is healthy for the economy because it encourages spending and means GDP can grow. But soaring inflation can do severe damage to living standards, as we've seen during the cost-of-living crisis.

Meanwhile, deflation (decreasing prices) is sometimes seen as being even worse than inflation. It can result in reduced consumer spending, as people put off purchasing things in the knowledge prices will fall.

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 the difference between deflation and disinflation?

It is important to note that, although the overall rate of inflation is slowing (e.g. from 2.2% to 1.7% on an annual basis between August and September), this doesn’t mean we are now experiencing deflation. Prices are still rising overall, just at a slower rate than they once were.

This is the difference between disinflation and deflation. Deflation is when the inflation rate falls below zero. Meanwhile, disinflation is when the rate of inflation is slowing but remains positive.

How is inflation calculated?

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 through several different indices, but the most widely reported is the Consumer Prices Index (CPI). The CPI 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 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 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 end, you'll need 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.

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 data is released at 7am. Find out the dates for the next inflation releases.

Where is inflation heading next?

According to forecasts, the path ahead is unlikely to be completely straight. Despite slowing to 1.7% in September, the Bank of England has said it expects inflation to “edge up to about 2.5% towards the end of the year before falling again”.

The experts at Dutch bank ING think CPI will rise to around 2.5-2.7% later this year. The consultancy Capital Economics is forecasting something similar, and has said it expects CPI to rebound to 2.7% by November.

Rising energy prices will be a big factor in this, after the Ofgem price cap surged 10% from 1 October. Petrol prices are also expected to rise in next month’s inflation report thanks to the conflict in the Middle East and rising oil prices.

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