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 rate of CPI inflation accelerated to 10.4% in February, defying analysts’ projections of a slowdown. 

The rate of inflation had slowed between October and January, and analysts were predicting it would come in at 9.9% in February. 

But food inflation is running at its highest-ever level, and prices at restaurants and hotels have also increased – both of which pushed the headline figure higher. 

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 by hiking interest rates

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

According to Kantar shoppers are facing an increase of £811 to their annual grocery bills

Energy bills, council tax bills, and petrol prices have also increased. 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 18.2% year on year to February, a food shop that might have cost £100 last year will now cost £118.20. 

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

Will inflation continue to rise?

The Office for Budget Responsibility (OBR) estimates inflation will fall to 2.9% by the end of 2023

The cost of energy has already begun to fall. In his Spring Budget, Jeremy Hunt announced he was extending the Energy Price Guarantee until July, meaning households’ energy bills will stay at £2,500 until then instead of jumping to £3,000 from April. 

The energy price cap, set by Ofgem, is predicted to fall to under £2,000 for the first time since 2022 in July, thanks to falling wholesale prices. 

“Inflation should resume its downward trajectory in March, when the strong base effect from the comparison to March 2022 – when Russia’s invasion of Ukraine sent fuel prices skyrocketing – is expected to lower the headline rate,” says Suren Thiru, economics director at the Institute of Chartered Accountants in England and Wales. 

But the core factors fuelling inflation, such as food prices, are proving sticky “because they form part of essential expenditure for many,” says Myron Jobson, Senior Personal Finance Analyst at interactive investor. “Britons are still spending which is not allowing the economy to cool and is keeping inflation elevated.”

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. 

Currently, the base rate sits at 4.25% – its highest level since 2008. Analysts are predicting rates could rise to 4.50% before the bank decides to slow down. 

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.

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 7%, which is far higher than they have been in recent years. 

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