How Inflation Works
...and how it doesn't
The latest UK inflation data was released this morning, and CPI was reported at 10.5%, slightly down from 10.7% the month before.
Inflation has been significant news for a while, and rising costs have resulted in the "cost of living crisis" that we are currently experiencing. In November, inflation reached 11.1%, the highest since October 1981.
Wherever we go, we can see and feel the impact of "inflation". Our bills have gone up at home, and our groceries are more expensive when we go shopping. Prices of holidays have increased, and even travelling at home has become more pricey, with rail fares rising.
Even if we can see and feel it, the actual definitions and figures that underpin the reported inflation figures are challenging to understand. With plenty of acronyms and over-simplified reporting, getting a simple and proper understanding of inflation is more complicated than it seems. Let's break it down.
What does it actually tell us?
The figure of 10.5% released this morning tells us that, on average, prices are 10.5% higher than they were at the same point a year ago.
The average price increase is across a "basket of goods" determined by the Office of National Statistics (more on this below). Therefore this representative basket of items is 10.5% more expensive today than it was this time last year.
There are reports today that inflation has "fallen" or “dropped”, which is slightly misleading. Inflation being a positive figure means that prices across the economy are still growing, just at a slower rate than they were this time last month (in this case, 10.7%).
One of Rishi Sunak's 5 public commitments for 2023 was to halve inflation. With the rate still above 10%, that means that this time next year, inflation could be at 5%, and he and his government would have achieved this goal.
The problem with that is that inflation is measured year over year. Therefore inflation in January 2024 of 5% would mean that prices are an extra 5% higher than they are today, where prices are already 10% higher than this time last year. If that is the case, we would likely be faced with a deepening cost of living crisis.
A more ambitious goal would be negative inflation (deflation) or prices falling across the economy. This is extremely rare. The last time the UK had an extended period of negative inflation was after the First World War when tight monetary policy (high interest rates) and tight fiscal policy (more tax) slowed the economy down and led to prices falling throughout the 1920s.
Is Inflation Always Bad?
Inflation is not always bad, and in fact, the government has a target of 2% inflation each year.
Having a low, controllable level of inflation is a sign of a healthy, growing economy, with growing demand contributing to slowly increasing prices. It is especially beneficial if wages are growing in line with inflation so the relative cost of living does not increase.
Inflation can be especially problematic if it is combined with low economic growth, which can be defined as Stagflation.
Stagflation?
Stagflation explains a period where costs rise alongside low or zero economic growth. Opposite to the scenario aimed for by governments - where prices rise due to healthy increases in demand - in a stagflation scenario, prices rise without increasing demand or economic growth.
This is a particular issue because the typical response from a government to inflation is to try and slow the economy down. They usually do this by increasing interest rates and making it more expensive to borrow money. However, in a situation where the economy is not growing in the first place, higher interest rates can trigger a recession.
Different Types of Inflation?
There are two main categories of inflation, the consumer price index (CPI) and the retail price index (RPI).
CPI is the most often used and reported as it is seen as the most relevant measure for what impacts the public and the government.
CPI and RPI are used to determine how much the cost of goods and services are going up over time. Both use a basket of goods, but the critical difference is that RPI includes mortgage interest payments (impacted by interest rates and house prices). This explains why RPI is higher than CPI at the moment and reached 14% in September 2022.
The ONS has written articles in the past explaining why they prefer to use CPI as a measure. It comes down mainly to the simplicity of calculation and the fact that house prices don't impact the day-to-day expenses of homeowners who have fixed or no mortgages.
What are the causes?
There are two leading causes of inflation: cost-push and demand-pull.
Demand-pull inflation is explained above in the example of healthy, manageable inflation that a government targets. Demand-pull inflation is where costs increase as a result of increased demand. When this is driven by increased output and household spending, this can signify a healthy economy.
Cost-push inflation is more akin to what the UK is seeing today. It is typically a result of a decrease in the supply of goods and services resulting from an increase in the cost of production. Tightening energy supplies across Europe due to the war in Ukraine, and the subsequent increase we see in our bills is one such example.
The Basket of Goods
Inflation in the UK is calculated by measuring the increased price of a basket of goods. The basket of goods for CPI is selected and designed to reflect items purchased by a typical household in the UK.
Prices of items in the basket may move at a higher or lower rate than the reported CPI. For example, whilst CPI has been around 10% over the last few months, prices of energy bills have gone up more than that for most. It is the average price increase of the basket as a whole that determines the rate of CPI.
Items in the basket change on an annual basis. In 2022, men's suits were removed from the basket, with the rise in working from home given as the reason. At the same time, craft/hobby kits for adults were added.
There are lots of items included in the basket that you might expect, certain foodstuffs, energy bills and rail fees, for example. But with over 500 items in the basket, there are certainly some more obscure items too!
To finish, let's look at ten of the most random items that are included in the basket of goods for UK CPI in 2022:
Meat-free sausages - the food section of the basket got a little more 'woke' in 2022. Veggie sausages were added due to the "growth in veganism... driven by the younger generations".
Nanny Fees - not an item in most households' baskets, but Nannies coming together and deciding to charge more to look after children would contribute to increased inflation.
DVD/Blu-ray player - despite no one in the country watching a blu-ray since 2005, they are still included in the basket.
Acoustic guitar - undoubtedly the most annoying item in the basket. The only silver lining to these going up in price would be a slimmer chance of someone getting one out at a party.
Ten-pin bowling session - you might need a little extra spare change if a bowling session goes up in price. It would also result in an increase in CPI.
Dating agency fees - the government might be trying to get CPI to return to single digits in 2023, but if the price of being single goes up, so will inflation.
Stockbroker fees - potentially the only item on the list that should have come down in 2022, given the quieter markets. You know, however, they'll be put up somehow.
Self Tanning products - looking good doesn't always come cheap. If looking good for you means having a year-round tan, this might be a relevant inclusion in the basket. Outside of Essex, perhaps not.
Caravans - the cost of living is undoubtedly a load we're all towing at the moment. If you spend your holidays driving your accommodation round, you'll be pleased to know that it's included in the ONS's basket of goods.
Condoms - and finally, to wrap up the list, something for the weekend.
