Different types of inflation explained

Inflation figures are reported each month. The figure (a percentage) is usually accompanied by comments about how the cost of filling our cars with fuel has increased or decreased and whether or not the weekly trip to the supermarket has become cheaper or more expensive.

And in 2021 and 2022 inflation became a headline grabber, as economies around the world emerged from the pandemic and supply chain issues caused prices to rise exponentially.

But what do the inflation figures that are reported every month actually mean? How are these numbers calculated and what do they include? How does inflation affect stock prices?

Perhaps, more importantly, how should we see inflation? Is it our friend or a foe? Here we take a detailed look at the topic and what you need to know.

What is inflation?

Let’s start with the basics. Simply put, inflation is a measure of how much prices of goods and services have gone up over time, expressed as a percentage.

By goods we mean items such as food, televisions or even cars. Services, meanwhile, include everything from beauty treatments to train tickets.

Generally, inflation looks at how much these things cost today, compared with 12 months ago. Therefore, when inflation is 4%, this means prices are 4% more than the previous year.

How much did things used to cost?

Take the example of a book selling for £10. If inflation is running at 4%, the new cost of the book would be £10.40 – a rise of 40p.

There are a number of inflation indices used to measure an uplift in prices, as well as various terms used to describe inflation itself. For example, core inflation is generally defined as the rate of price rises excluding more volatile inputs such as energy.

How is inflation measured?

So, how does everyone know the amount by which prices have risen? This is down to the work of the Office for National Statistics (ONS).

The ONS is the largest independent producer of official statistics and responsible for collecting and publishing information relating to the economy, population and society.

Every month, the ONS collates around 180,000 prices of 700 items. This is referred to as the ‘shopping basket’ of commonly-used goods and services. The quantities, also referred to as the ‘weight’, of the various items in the basket are chosen to reflect their importance in the typical household budget.

By comparing movements in the cost of this basket, the ONS calculates what is known as the Consumer Prices Index, or CPI. This is used as the measure of inflation.

What is the inflation target?

The ideal scenario is for inflation to be low and stable. When it’s running at a high level it means that incomes can’t keep pace with the rising costs of living. This is why the UK Government sets the Bank of England the target of keeping inflation at 2%. If it misses this target – by one percentage point either side – it has to explain itself.

Therefore, when inflation is either less than 1% or more than 3%, the Bank’s Governor will write a letter to the Chancellor of the Exchequer outlining what’s happened.

Traditionally, the Bank’s way of controlling inflation is through interest rates. This means the cost of borrowing goes up and that has the effect of stopping people spending so much.

The impact of inflation

An inflationary environment generally means we still have the same amount of money to spend but it doesn’t go as far because everything is more expensive. This affects our purchasing power.

It means weekly trips to the supermarket will cost more for exactly the same items, while rising fuel prices sees drivers having to pay extra to fill up their tanks.

We examined how prices in the UK have changed over time by using the Bank of England’s inflation calculator that uses data up to 2021.

For example, something that cost £10 back in 1950 would now be £364.61, with inflation having averaged 5.2%!

You can even see the increases over the last five years. You would have needed to pay £12.59 in 2021 for an item that would have been sold for £10 in 2016.

The impact of inflation on stock prices will depend on how the individual sector – or business itself – is being affected by the higher prices.

Different types of inflation

Economists will declare there are different types of inflation. The most common forms you may hear about are demand-pull and cost-push.

Demand-pull is when there is more demand for goods than there is supply. This is often seen as a healthier type of inflation as it’s caused by higher employment and wages.

Cost-push, meanwhile, occurs when the cost of making goods increases and companies have to raise their prices in order to cover the shortfall. However, this can obviously put a strain on the consumer.

There is also the concept of built-in inflation. This is when expectations of future inflation actually end up causing inflation itself.

The idea is that as prices rise, workers demand higher wages to help them cover the spiralling costs. In turn, this causes production costs to rise, which can lead to prices going up again…and so on.

What is disinflation?

Disinflation is still a period of inflation, but prices are rising by smaller amounts than they were before. In other words, the rate of inflation is falling.

In some cases, disinflation can suggest unemployment is rising or economic growth is slowing. It can also come about when central banks raise interest rates.

What is deflation?

The opposite of inflation is deflation. This is when the percentage measure of inflation drops below zero, meaning goods and services become cheaper.

On the face of it, this sounds great. If everything is less expensive it should mean that you can afford to buy more items – including those that were previously out of your budget. However, it’s not quite that straightforward. The issue is that, because the value of your cash increases, you are more incentivised to hold onto your money in savings than spending it.

Also, when prices fall there is the expectation that this will continue and a coveted item may be even cheaper tomorrow. As a result, people hold off on making a purchase.

A downside of fewer products being bought is companies’ revenues falling. This can lead to higher rates of unemployment as businesses are forced to cut costs. The subsequent continued downturn in spending is known as a “deflationary spiral”.

What is stagflation?

Stagflation occurs when there is no economic growth and unemployment is rising, but there is still inflation in the system. In other words, your wages would be falling, but the price of goods would keep rising. Of course, this is not an ideal environment for anybody! Stagflation tends to be the result of ‘bad’ or ‘cost-push’ inflation.

The concept of stagflation has been around for more than half a century. Back in the 1970s, for example, developed economies experienced rapid inflation and high unemployment due to an oil embargo. It also became a worry in 2022. 

What is reflation?

Reflation essentially signifies the start of the inflationary cycle after a recession. It is often regarded as the opposite of disinflation.

It shouldn’t be confused with full-blown inflation, which we have already outlined, as it tends to happen more gradually.

Reflation occurs when the economy starts to experience stronger growth in conjunction with rising prices. This can be caused by central banks injecting more cash into the economy through actions such as reducing taxes, printing money or lowering interest rates.

The idea is that as economic growth improves, demand for goods increases, companies make more products, and more staff get hired. Another positive of this backdrop is that it should lead to higher wages as companies continue to thrive.

Reflation also benefits the government because, as corporate profits improve and more people return to the workforce, they receive more tax revenue. As an added bonus, the government should also spend less money as benefit payments fall.

 

This article was originally published 13 March 2018 and updated on 16 July 2020 and 18 March 2022.

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