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What is inflation?  How does it work?  Is it good or bad for business?

We are often asked about inflation and the affect it has so here is our brief guide to the essentials you need to know:

What is it?

Inflation is the percentage rate at which goods and services increase in price.  The higher the rate, the less far your money goes.

It is expressed over time so if inflation for the year is 2%, it means that a tank of petrol will cost you 2% more than it did a year ago.

If wages don’t keep pace with the rate then people cannot afford as much as they previously could, and the standard of living drops.  In general, a little inflation increases growth as people buy things early ‘before they go up’, which means businesses have more money to increase wages.  That is why the central banks of most countries aim to have an inflation rate of between 2% and 2.5%.

How is it calculated?

Inflation is measured by the Office for National Statistics (ONS) and they produce three main estimates of inflation:

  • the Consumer Prices Index (CPI)
  • the Consumer Prices Index including owner-occupiers’ housing costs (CPIH)
  • the Retail Prices Index (RPI)

The CPI is the most commonly used and known figure, and it takes into account the prices of thousands of items that people commonly spend money on.

The prices are weighted, so that more prominence is given to the items that consumers spend more on. For example, people spend more on fuel than they do on stamps so any increase in fuel will affect inflation more than an increase in stamps.

What is the point of the rate?

It is one key factor the Bank of England considers when setting the “base rate” and that influences what interest rate banks can charge people to borrow money, or what they pay on their savings.

If it thinks inflation is likely to be below 2%, it may cut interest rates to lower the cost of borrowing make saving less attractive, therefore encouraging spending and keeping the economy stimulated.

Is it good or bad?

As with most things, it depends on which side of the fence you are. If you are a borrower with a fixed rate mortgage then higher inflation essentially reduces that debt – everyone has more so the debt costs less to repay in real terms.  Governments and businesses with debts will also benefit as their debt is effectively reduced as well.

However, if you are a saver or have a pension, then inflation will be bad for you – your money will not buy you as much as it once did so your pot may not be enough to live the life you planned.

As prices rise, workers will be asking their bosses for pay rises in order to maintain their usual lifestyle which in turn puts pressure on the bosses to increase their prices to cover the rise, and then the cycle begins again if not properly managed.