Inflation: what it is and why it matters - Aviva

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Inflation: what it is and why it matters

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A new official inflation figure is released each month, and it typically receives a lot of media coverage.  But what is inflation, how is it calculated and why does it matter?

What is inflation?

Inflation is a measure of how fast prices are rising (or falling) over time. It is currently reported to be approximately 3%[1]. So, on average, prices are approximately 3% higher today than the prices we experienced a year ago.  In other words, we need to spend 3% more today to buy the same things we bought 12 months ago.

How is inflation calculated?

Prices of different goods and services rise and fall at different paces between different locations. The headline inflation figure is therefore an average of all these different prices movements.

To calculate the headline figure, the Office for National Statistics gathers around 180,000 separate price quotations every month, covering around 700 representative consumer goods and services. These prices are collected across around 140 locations and from the internet and over the phone[2]. These 700 goods and services are referred to as the UK’s ‘basket of goods’.

To ensure the basket of goods keeps pace with our modern shopping habits, it is updated every year. For example, over recent years cycle helmets, jigsaws and electronic cigarettes have been added to the basket – reflecting their growth in popularity[3]. Meanwhile, DVD rentals, a bar of soap and nightclub entry have been removed[4]. To avoid misunderstanding, the bar of soap has not been removed because we are washing less, but because it has been replaced with liquid soap!

The headline average also takes into consideration how much we spend on these different goods and services. For example, there is a current assumption that we spend the biggest proportion of our money (27%) on housing and household services; about 8% on food and non-alcoholic drinks; and about 6% on clothing and footwear[5].

The headline average also avoids significant price movements of individual goods and services having an undue influence on the inflation figure that is reported. For example, in May 2017, if we had we only measured the price of fish, we would have recorded an inflation figure of +10%! Alternatively, had we only measured the price of soft drinks we would have recorded an inflation figure of -2%[6]. The exercise of calculating an average balances these individual price differences.

Why does inflation matter?

This may be interesting, but why should we be bothered?

As shoppers, we typically enjoy a bargain, so we instinctively dislike big price rises. Big price rises, however, will matter more if our wages are not keeping pace.

If in year one prices rise by 3% and our wages also rise by 3%, then we should be able to buy the same amount this year as we did last. If however, in year two, a 3% price rise is met by a wage rise of only 1%, we will not be able to buy as much this year. In these circumstances, high inflation and fast rising prices will impact our quality of life. In these circumstances we will have experienced a 2% drop in the buying power of our wages.


Just as too much inflation is bad, too little inflation is also bad. If prices are falling – also known as deflation - shoppers will typically wait before buying in the belief that things may be cheaper next month. This act of waiting can result in a slump in the economy, which again is not good for our quality of life.

The Bank of England has a responsibility for ensuring our inflation is neither too high, nor too low. The government sets the inflation target and this currently stands at 2%. This is seen to be the right level of inflation to grease the wheels of the economy and get us spending, without it negatively impacting our long-term quality of life.

The primary tool the Bank of England uses to manage inflation in the economy is interest rates. If the Bank feels the economy needs a boost, it may cut interest rates to encourage borrowing and spending. If the Bank feels the economy needs to cool down, it may raise interest rates to encourage saving and discourage spending. Given the difficulty experienced by the UK economy over recent years, it is now ten years since the Bank of England last raised interest rates, in July 2007[7].

We’ve written an article on how interest rates are set – take a look to find out more about the impact they could have on your finances.

So, the headline inflation figure covers many, many underlying price movements. It matters to us as individuals and also to the economy as a whole. During recent times, we have seen inflation on the rise. People are asking whether this trend will continue, and wondering if the Bank of England could choose to increase interest rates for the first time in a decade. Time will tell.

 

WC04351 07/2017

Additional sources

[1] Source: https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/may2017

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