What Is Inflation?

The simple version

Inflation is the rate at which prices across the economy are going up over time. If inflation is 3%, things cost roughly 3% more than they did a year ago. A £50 shopping basket now costs £51.50.

A small amount of inflation is actually considered healthy — it encourages spending (why buy something tomorrow when it costs more?) and gives businesses confidence to invest. The problem comes when it gets too high, or when it falls so low it tips into deflation.

How is inflation measured in the UK?

The main measure is the Consumer Price Index (CPI). The Office for National Statistics (ONS) tracks the prices of around 700 goods and services — a virtual ‘basket’ of things households typically buy, from bread and fuel to cinema tickets and laptops. Each month they measure how much that basket has changed in price compared to a year ago.

You might also hear about CPIH (which adds housing costs like rent) and RPI (an older measure still used for some rail fares and student loan interest). CPI is the official government and Bank of England measure.

What does inflation mean for your money?

This is where it gets personal:

• Savings: If your savings account pays 3% interest and inflation is also 3%, your money isn’t actually growing in real terms — it’s just keeping pace. If inflation is higher than your interest rate, your savings are losing purchasing power even if the balance is going up.
• Wages: A 2% pay rise when inflation is 5% is effectively a pay cut. Your salary needs to at least match inflation to maintain your standard of living.
• Debt: Inflation actually helps debtors in one sense — the real value of what you owe falls over time, because you’re repaying with money that’s worth slightly less.
• Pensions: The State Pension rises each year by the highest of inflation, average earnings growth, or 2.5% — this is called the ‘triple lock’.

Why does the Bank of England care about inflation?

The Bank of England’s primary job is to keep inflation at 2%. When it strays too far from that target — in either direction — the Bank adjusts the base rate:

• Inflation above 2%? Raise rates. More expensive borrowing slows spending and reduces upward pressure on prices.
• Inflation below 2%? Cut rates. Cheaper borrowing encourages spending, which pushes prices back up.

If inflation goes above 3% or falls below 1%, the Bank Governor must write an open letter to the Chancellor explaining why.