A beginner's guide to inflation

A beginner's guide to inflation

Ever wondered why everything just keeps getting more expensive? There’s a simple answer in most cases. It’s inflation.

You’ve probably seen, heard and read this term countless times. On the news, in the papers, online and in everyday conversation. But what does it actually mean? If you didn’t already know, our essential guide to inflation is here to help you understand things a little better.

What is inflation?

To put it very simply, inflation is the process of prices increasing over time. The rate of inflation is a measure of how quickly this is happening. It’s usually shown as a percentage, which represents the relative increase in prices over a certain period.

Inflation impacts everything from energy and fuel prices to the cost of rent and what you’re putting in your trolley. It affects businesses and organisations, as well as individuals and households. More on why this happens and what it means for you later.

What is the current inflation rate?

As of July 2024, prices in the UK rose 2.2% in the prior 12 months. This is based on something called the Consumer Price Index (CPI), which tracks the price of over 700 things people buy regularly.

The inflation rate rises and falls due to several factors, as it has done consistently over the years. You can see the general trend in the CPI graph published by the Office for National Statistics (ONS). October 2022 saw the inflation rate rise to 11.1% – the highest it had been for 40 years.

How is inflation calculated?

It’s quite simple, really. The ONS tracks the prices of everyday items and services in its CPI ‘basket of goods’. By comparing these 12 months apart, the difference can be used to calculate the rate of increase (inflation).

This basket of goods includes essentials such as food, clothing, transport and utility bills. It’s updated in line with consumer trends each year. The most recent additions for 2024 include gluten-free bread, air fryers and vinyl music.

The CPI groups these essentials to give an estimation for inflation across society. However, inflation can be worked out for individual items, too. For example, if the price of bread was £1.00 one year and £1.10 the next, the annual rate of inflation for a loaf would be 10%.

What factors drive inflation?

A wide range of factors can drive or influence inflation across society. These can be divided broadly into two main categories: cost-driven and demand-driven inflation.

Cost-driven inflation

This is often referred to as ‘cost-push inflation’. This happens when the cost of production for products and services increases, causing consumer prices to rise as a result.

Significant global and national events often influence this. For example, spikes in inflation rates over the last few years were largely caused by the pandemic and Russia’s invasion of Ukraine.

A fall in the supply of gas from Russia meant the UK had to spend more to import energy sources from elsewhere. In turn, this increased the price of household and business energy tariffs, increasing prices elsewhere.

Demand-driven inflation

The other main reason prices tend to rise is when demand increases. As people earn more and have more to spend, their purchasing power becomes greater. This usually happens when the economy is healthy and growing. If supply levels don’t match this increase in demand, prices are bound to go up.

More buyers in the property market means house prices rise. More shoppers wanting clothes and technology gives retail businesses the freedom to charge more. More holidaymakers booking seats on flights means airlines can ask for more without impacting sales.

Does anyone control inflation?

Inflation can’t be controlled, per se. But the UK rates are closely monitored by the Bank of England. A small, stable amount of inflation in an economy is completely normal and can be useful. It helps companies contribute to things like rising wages. But when it becomes too high, low or unpredictable, economies tend to suffer.

The government currently has a target of keeping inflation at 2% per year, which shapes some of the Bank of England’s policies. To keep inflation rates in check, they can vary the base interest rate across society, which is known as the ‘Bank Rate’.

It’s been higher in recent years in an attempt to slow inflation. By making it more expensive to borrow and spend, and more rewarding to save, demand falls and businesses should be less willing to increase their prices.

You can read more about how interest rates  work in our handy guide.