Katie Williams
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.
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After falling from a peak of 11.1% in October 2022 and returning to the Bank of England’s 2% target last year, inflation has risen again in recent months.
Following a low of 1.7% in September, inflation (as measured by the Consumer Prices Index) rose to 2.3% in October and 2.6% in November. It fell back slightly to 2.5% in December, but is expected to rise again when January's report is published on 19 February.
We take a closer look at what this means and how inflation impacts your finances.
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?
Despite rising above the Bank of England’s 2% target in recent months, the rate of inflation has slowed significantly from its peak (11.1%). This doesn’t mean we are now experiencing deflation, though. 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. The basket 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). 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 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 inflation rate for the previous monthly period. The data is released at 7am.
For a full list of upcoming reports, see our calendar of CPI release dates.
Where is inflation heading next?
Inflation is expected to pick up over the course of 2025, potentially hitting 3.7% in the third quarter, according to the latest forecast from the Bank of England.
Higher global energy prices are likely to be the main factor driving the increase. The Ofgem energy price cap rose by 1.2% in January and is expected to rise by a further 2.7% in April.
The Bank of England has said that it expects domestic inflationary pressures to continue to wane overall, although we could see increases in some categories.
For example, the introduction of VAT on private school fees from the start of January 2025 is expected to drive up the rate of inflation. Water bills will also rise by an average £123 per year from April.
Businesses could also raise their prices later this year to offset the cost of higher National Insurance contributions.
Not everyone agrees with the Bank of England’s forecast, though. In a report published on 12 February, the National Institute of Economic and Social Research (NIESR) said it expects January’s inflation reading to come in at 3.2%, before falling slowly back to target. It expects inflation to average out at 2.4% in 2025 as a whole.
We share further analysis on the outlook for UK inflation in a separate piece.
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