What is inflation and how is it calculated? UK rate drops below 10% for the first time since August

·6-min read
At 19.1% in April compared with 19.2% in March, food price inflation stayed close to 45-year highs ((Alamy/PA))
At 19.1% in April compared with 19.2% in March, food price inflation stayed close to 45-year highs ((Alamy/PA))

The UK's inflation rate (announced on May 24) decreased from 10.1 per cent in March to 8.7 per cent in April, but food prices remain high.

At 19.1 per cent in April compared with 19.2 per cent in March, food price inflation stayed close to 45-year highs.

The Office for National Statistics (ONS) said the decrease in the main rate was caused by the stability of energy prices this year compared with significant increases last year. It said this was counterbalanced by notable increases in the cost of cigarettes and used cars.

The ONS said in its report: “Electricity and gas prices contributed 1.42 percentage points to the fall in annual inflation in April as last April’s rise dropped out of the annual comparison, but this component still contributed 1.01 percentage points to annual inflation.

“Food and non-alcoholic beverage prices continued to rise in April and contributed to high annual inflation, however, the annual inflation rate of food and non-alcoholic beverages eased, from 19.2 per cent in the year to March 2023, to 19.1 per cent in the year to April 2023.”

The Financial Times reported on May 24 that the Bank of England had expected consumer price inflation to drop from 10.1 per cent in March to 8.4 per cent last month as 2022 energy price rises fell out of the annual comparison.

But what is inflation, what causes it, and how is it calculated? Here’s everything you need to know.

What is inflation?

Inflation is an economic concept that refers to the general increase in prices over time. It means that, on average, the cost of goods and services is rising, and the purchasing power of money is diminishing. Inflation is a common occurrence in most economies and can impact various aspects of daily life, from the prices of everyday goods to savings and investments.

When inflation occurs, the same amount of money can buy fewer goods and services compared to before. This is because as prices rise, consumers need to spend more money to maintain their standard of living. For example, if the price of a loaf of bread increases, individuals will need to allocate more money to purchase the same loaf.

Inflation erodes the value of money over time, making it important for people to consider the impact on their budgets and financial planning.

What causes inflation?

Inflation can occur for various reasons. One common cause is when there is an excess of money supply in the economy relative to the available goods and services. When there is more money chasing the same amount of goods, prices tend to rise.

Additionally, inflation can be influenced by factors including increased production costs, such as raw materials and wages. For example, if a bottle of milk costs £1 and that rises by 5p compared with a year earlier, then milk inflation is five per cent.

The Bank of England had, in May 2023, expected consumer price inflation to drop from 10.1% in March to 8.4% last month as 2022 energy price rises fell out of the annual comparison. (PA Archive)
The Bank of England had, in May 2023, expected consumer price inflation to drop from 10.1% in March to 8.4% last month as 2022 energy price rises fell out of the annual comparison. (PA Archive)

Inflation can also result from changes in consumer demand, exchange rates, and government policies.

In the short term, high inflation can also be the result of people having a lot of surplus cash, or accessing a lot of credit and wanting to spend.

Despite consumers receiving little to no benefit from inflation, investors can profit if they hold assets in markets affected by it. For example, those who’re invested in energy companies might see a rise in their stock prices if energy prices are rising.

How is inflation calculated?

Inflation is calculated using various methods, but one common approach is to calculate the percentage change in a price index over a specific period. Here’s a simplified explanation of how inflation is calculated using this method:

  1. Select a price index: A price index is a measure of the average price level of a basket of goods and services in an economy. Different countries have their own price indices, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI). The CPI, which the UK uses, is commonly used to measure inflation at the consumer level.

  2. Determine the time period: Choose a specific period for which you want to calculate inflation, such as a month, a quarter, or a year.

  3. Obtain the price data: Collect the price data for the items included in the price index basket for the beginning and end of the chosen time period. The prices can be obtained through surveys, market observations, or other data sources.

  4. Calculate the inflation rate: Use the formula to calculate the inflation rate:

    Inflation rate = ((Current Price Index - Previous Price Index) / Previous Price Index) * 100

    Subtract the previous price index from the current price index, divide by the previous price index, and then multiply by 100 to express the result as a percentage.

For example, let’s say the CPI at the beginning of the year was 200 and at the end of the year, it increased to 210. The inflation rate for that year would be:

((210 - 200) / 200) * 100 = 5 per cent

This means that the general price level, as measured by the CPI, increased by 5 per cent over the course of the year.

What effects does inflation have?

Inflation has several effects, including reduced purchasing power as prices rise, creating challenges for individuals and businesses in planning and budgeting. It can lead to wealth redistribution, benefiting debtors and hurting creditors.

Inflation also impacts investment decisions, with individuals seeking assets that outpace inflation. Traditional savings instruments may suffer from erosion of value. High inflation rates introduce uncertainty and distortions in the economy, affecting business planning, long-term investments, and price signals.

Inflation occurs when the general price level of goods and services in an economy rises over time (Evening Standard)
Inflation occurs when the general price level of goods and services in an economy rises over time (Evening Standard)

Inflation can become a destructive force in an economy if it is allowed to get out of hand and rise dramatically.

Unchecked inflation can topple a country’s economy, as it did in 2018, when Venezuela’s inflation rate hit more than 1,000,000 per cent a month. This caused the economy to collapse and forced countless citizens to flee the South American country.

What does inflation mean for mortgages?

Rising inflation will have an impact on homeowners, but how much depends on the terms of their mortgage.

The Bank of England may increase interest rates to try to slow inflation when it rises.

As a result, when interest rates rise, mortgages can become more expensive, although this will depend on their type.

People who have tracker mortgages, which track a base rate (usually the Bank of England’s), will see their interest rates rise a month after the Bank of England increases the base rate.

Meanwhile, people on fixed-rate mortgages won’t be affected immediately. These mortgages fix the interest rate a homeowner will pay for a certain length of time — usually two years or five years.

Once a tracker or fixed mortgage comes to an end, lenders can put borrowers on a standard variable rate (SVR) mortgage. This means mortgage payments could change each month, depending on the rate.

What does inflation mean for wages?

Inflation can impact wages in several ways. It often leads to higher nominal wages as workers demand raises to keep up with rising prices.

However, the effect on real wages, which account for inflation’s impact on purchasing power, depends on whether wage increases outpace inflation.

Inflation can also influence wage negotiations and expectations. It may result in a redistribution of income, benefiting those with rising wages while potentially impacting those with fixed incomes.

Various factors and individual circumstances can shape the relationship between inflation and wages.