A two-minute guide to inflation

Inflation is the buzzword of the month. It’s being talked about in the US, here in the UK – everywhere around the world in fact. It’s not something I’ve really come across before, but my parents are very weary. So, just what is inflation? How is it measured? And is it always a bad thing?

“Inflation is taxation without legislation.” – Milton Friedman, American economist

What is inflation?

Inflation describes the gradual rise in prices and slow decline in purchasing power of your money over time. Think of it like this: does your monthly pay cheque go as far as it used to or are the things you buy getting more expensive and you find you’re having to watch your spending?

In the UK, inflation is calculated by the Office of National Statistics. It creates an imaginary ‘shopping basket’ of the things you and I buy on a regular basis. When the basket was first introduced more than 70 years ago, condensed milk and a mangle were among the items. Today it contains things like hand sanitiser, cappuccino sachets, cocktails in a can and small pets.

Some 80,000 prices are collected on 720 goods and services in 140 locations around the UK and are used to see if the price of these goods and services are rising or falling. This is called consumer price inflation or CPI.

CPI figures are reported each month as a percentage. In simple terms, they effectively tell you whether your weekly trip to the supermarket has become cheaper or more expensive. For example, if the cost of coffee is £1 and rises by 5p then the coffee inflation is 5%. It also applies to services too, like having your nails done or getting your car MOT.

The push and pull of inflation

Demand-pull inflation is when there is more demand for goods than there is supply, so people are willing to pay more to secure the purchase. This is typically a ‘healthier’ type of inflation – it typically moves in-line with a rise in employment and wages and, because we have more money in our pockets, we don’t mind spending more.

Cost-push inflation is when the cost of making goods increases and companies must raise their prices in order to cover the shortfall. People may start to buy more than they need to avoid tomorrow’s much higher prices. This increased buying drives demand even further so that suppliers can’t keep up. This can put a strain on the consumer and therefore negatively impact the economy. It can also mean that common goods and services are priced out of the reach of most people.

Is inflation good or bad for our finances?

A small to moderate inflation rate is seen as a sign of a healthy economy. It encourages you to spend or invest your money today, rather than stuffing it under your mattress only to watch its value diminish. The flip side however can be destructive.

If inflation rises quickly, central banks – like the Bank of England – will often tackle the issue by raising interest rates. If interest rates rise, then the cost of mortgages, student loans, and other borrowing will go up. Ultimately, people and businesses will have less money to spend, demand will fall, and prices will stop rising so quickly.

Inflation, when allowed to get out of hand and rise dramatically, can topple a country’s economy. For example, in 2018, Venezuela’s inflation rate hit over 1,000,000% a MONTH causing the economy to collapse. This is known as hyperinflation. Although rare, hyperinflation describes out-of-control inflation that cripples consumers’ purchasing power and economies. Economists define hyperinflation as taking place when prices rise by at least 50% each month.

Inflation comes in many forms, from the extreme case of Venezuela to the healthy 10p increases we hardly notice. The inflation rate is used to inform a whole range of decisions and is keenly watched by economists as a sign of what’s going on in the economy.

Learn more about other types of inflation here