What is inflation and how will it affect you?

There has been much talk of inflation recently. But what exactly is it and what does it mean for our money?

The latest UK inflation figures were published on 16 November, showing inflation rising by 11.1% or more, up from 10.1% and higher than many economists predicted. 

Double-digit inflation eats away at wages and purchasing power, erodes savings, and tends to affect the poor the worst. That’s why policymakers are trying to stamp out the “scourge” of inflation. 

For most people, inflation is manifesting itself in the cost-of-living crisis as households are under increasing pressure from rising prices. 

The price of food in the UK is a great example. The latest figures from Kantar show food and drink prices rose at their fastest pace in 14 years in October, up by 14.7%. 

The same is true for energy bills, house prices, petrol and many other items. In fact, you’d be hard-pressed to find something that isn’t costing more this year than it was last year.  

If all these figures seem confusing, you’re not alone. The headline inflation figure is just a number. Inflation affects different people in different ways. 

So, how is inflation calculated? Will it continue to go up? And, most importantly, how does it affect you?

How is inflation calculated?

In the UK, the Office for National Statistics (ONS) keeps track of the prices of a range of items in a “basket” of goods and services made up of over 700 things people regularly purchase. 

The overall price of that basket is known as the Consumer Prices Index, or CPI. To calculate inflation CPI is compared to what it was a year ago, and the change in the price equals the change in the rate of inflation. 

Other measures of inflation, such as the Retail Price Index (RPI) and Consumer Prices Index including owner occupiers' housing costs (CPIH) use the same method but different inputs. That’s why they tend to have a different reading to CPI. 

However, CPI is the most commonly used and widely accepted metric. 

Why is inflation a problem?

The rising cost of items erodes consumers’ purchasing power, meaning they get less for their money. 

For example, with food prices up 16.2% year on year, a food shop that might have cost £100 last year will now cost £116.20. A lot of people, especially at the lower end of the income spectrum, don’t have the extra money available to meet these rising prices. 

So consumers begin purchasing less, which slows down the economy and can lead to a recession. 

The Bank of England has recently warned that the UK is facing its longest recession since records began

Will inflation continue to rise?

The Bank of England (BoE) expects inflation to fall back to around 5% by the end of next year. However, there are several macroeconomic factors that are pushing prices up, which the bank cannot control.

Chief among them is the rising cost of energy. Demand increased after the pandemic and the war in Ukraine affected the oil and gas supply from Russia. Higher energy prices are pushing up costs for virtually every business and most are passing these costs onto customers, driving inflation. 

The war in Ukraine also pushed the cost of food up because the country produces a large amount of the world’s grain. 

The BoE expects inflation to peak at 11%, but whether it will climb higher remains to be seen. A lot depends on energy prices. The government’s Energy Price Guarantee has put a lid on energy prices for the time being, and it’s starting to look as if energy prices will moderate next year

What is the bank doing to control inflation? 

The BoE has an inflation target of 2%, and it’s currently running at five times that. In order to control inflation the central bank has been raising interest rates. This increases the cost of borrowing, which means higher interest rates on mortgages, credit cards, loans and any other type of debt. The hope is it will encourage people to save their money. 

If people are spending less, demand will fall and theoretically, so should prices, which would bring inflation down. 

The BoE most recently raised rates on 3 November, by 0.75% to 3%. They are at their highest level since 2008. The BoE’s rate-setting committee is due to meet again on 15 December, and it remains committed to increasing interest rates to get inflation under control

Some economists are predicting rates will climb to 5.25%. 

How does inflation affect you? 

Rising prices will have an effect on your budget, and potentially reduce the number of things you can afford. 

Furthermore, rising interest rates will also mean mortgage repayments will be more expensive, which might make you consider fixing your mortgage. The cost of borrowing in general will continue to rise. 

However, rate rises do mean good news for savers, who might want to think about storing their cash in a savings account with a fixed rate while they have the chance. 

We have compiled a list of the best savings accounts available right now. They’re currently sitting at up to 5%, which is far higher than they have been in recent years.

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