Inflation

Inflation is the rise in the general level of prices in an economy (or a sector of an economy) over a given period of time. Alternatively, it is sometimes defined as the decline in the purchasing power of each unit of money, which amounts to the same thing.

Inflation is usually measured by looking at the change in a price index that is based on the average prices of a basket of goods and services. Typically we look at the year-on-year inflation rate (eg, the change in the price index between May this year and May last year), or the annualised rate over longer periods (eg, if the price index is up by 9.3% over three years, that’s an annualised inflation rate of 3%).

When we talk about inflation in general, we are usually referring to inflation in the consumer price index (CPI). This index is a representative sample of the items a typical consumer spends their money on, such as food, fuel, clothing and entertainment. However, we might also want to know about changes in the prices that manufacturers receive for what they sell. This is measured using a producer price index (PPI), based on a basket of products ranging from raw materials to finished goods. Changes in the PPI generally precede changes in the CPI since rising or falling costs for producers (such as materials or labour costs) will ripple down the supply chain until they affect the prices that consumers pay in shops.

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Calculating inflation is surprisingly complicated. The selection of items in the index, the mathematical method used to average them and adjustments to reflect changes in the quality of items over time all affect the result. Two indices may produce different rates, as is often the case with the UK’s CPI and its older retail price index (RPI). Important items such as food and fuel have volatile prices, so we may need to look at an index that excludes these to get a sense of underlying trends (known as core inflation).