What is inflation and why is it important?

10th February 2018

The Consumer Prices Index (CPI) inflation rate for Decmber 2017 fell by 0.10% to 3% but it’s nearly double what it was in December 2016, when it stood at just 1.60%. The January 2018 inflation figures will be released next Tuesday – 13th February.

Statistics like this are always in the media but what does it mean and why is inflation so important?

Inflation is the rate of increase in the prices of goods and services, expressed as an annual percentage. So, with inflation currently standing at 3%, this means that, on average, the price of goods and services is 3% higher than they were a year ago.

How is inflation calculated?

One way to understand this is to think of a shopping basket containing all the goods and services bought by households.

Every month, the Office for National Statistics (ONS) collects around 180,000 separate prices of about 700 items covering everything from food and drink to clothes, furniture and train fares – and these prices are collected from about 140 locations across the UK and from the internet and over the telephone. 

It also takes into account the importance of some items in a typical household so some items, such as tea and coffee, are given more importance in the inflation indices than others. 

Each year the items are reviewed, some are taken out and some are brought in to make sure that the basket is still representative and relevant.

In 2017, 16 items were added, 11 were removed and eight were modified. For example, flavoured cider has been added due to an increase in expenditure and shelf space devoted to it. And cycle helmets have also been added, which represents the growing popularity of cycling.

On the flip side, child’s swings have been replaced by child’s scooters, reflecting the former’s falling availability in the shops.

This ‘basket of goods’ is used to calculate the CPI and the ONS publishes an updated rate every month.

While some things have increased in price, others have decreased, but currently, overall, the basket of goods is 3% higher than it was a year ago, so you’d need to spend 3% more to buy these same items you bought 12 months ago.

Of course, everyone will have their own personal inflation rate, depending on which of the items in the CPI basket they use. For example, a couple of key drivers of the drop in December’s CPI were lower air fares and a fall in the cost of games and toys. However, there were also upward pressures such as an increase in the price of tobacco products and an increase in petrol and diesel. So, if you never fly and rarely buy games and toys, but smoke and drive a lot, your personal inflation rate has possibly not fallen!

CPI is currently the inflation measure used in the Government’s inflation target, but there are other measures of inflation, such as the CPIH which as the name suggests is the Consumer Price Index but includes the costs associated with owning, maintaining and living in one’s own home (including council tax) and the Retail Price Index (RPI)

Those of you who have NS&I Index Linked Certificates, will be pleased to know that these are linked to the Retail Prices Index (RPI). Which at 4.10% in December 2017, is currently the highest of the three.

 

Why set an inflation target?

Maintaining price stability encourages long-term growth in the economy and therefore the Government sets an inflation target for the Bank of England to support a stable and healthy economy. Generally, when people feel like spending – and therefore demand for goods and services exceeds supply – inflation tends to rise. When people reduce their spending and supply exceeds demand, inflation tends to fall. 

 

How is inflation controlled?

One of the tools used by the Bank of England is the official Bank of England interest rate (also known as Bank Rate or the Base Rate).

This is the rate of interest that is paid on reserves held by commercial banks at the Bank of England.

The Bank of England’s Monetary Policy Committee (MPC) is responsible for making decisions about the Bank Rate and is made up of nine members – the Governor, the three Deputy Governors for Monetary Policy, Financial Stability and Markets and Banking, our Chief Economist and four external members appointed directly by the Chancellor of the Exchequer. And it meets eight times a year to review and decide what the official Bank of England rate should be.

So, ignoring other influences, if inflation looks set to go above target, the MPC would probably increase interest rates so people spend less, which tends to reduce inflation. Or if inflation looks likely to fall below target, they would probably cut interest rates to boost spending in the economy and help inflation to rise.

If inflation exceeds the target by more than 1 percentage point either side – in other words, if the CPI inflation rate is more than 3% or less than 1% – the Governor of the Bank of England must write a letter to the Chancellor. This letter explains why inflation has increased or fallen and what the Bank of England proposes, to make sure it comes back to target.

Of course, we know that it’s not as simple as that, but with inflation continuing to remain 1% above target, although it remained on hold this month, it’s another reason that there is so much speculation about another base rate rise on the horizon.

Watch out for January 2018 inflation figures, which will be released on Tuesday 13th February and the next MPC decision regarding the official Bank of England Base Rate is planned for Thursday 22nd March

As always we will keep you up to date with all the changes that could affect your savings in our weekly newsletter, but do call us if you have any further questions on 0800 321 3581.

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