If you remember getting pocket money as a child you'll know that in today's world it probably wouldn't go very far. That's because the price of things have gone up over time with inflation.
Inflation & the cost of living
Inflation affects the value of what you've got to live on. If prices rise and the money you have to live on doesn't increase, the value of what you have to spend is less. Think back to September 2011 when we were in the midst of recession and inflation went up to 5.2% 1. Many people had to cut back on their spending as the money they had to live on didn't go up but the price of everything like food and fuel did.
How we measure inflation
In the UK, the main measure of inflation is the Consumer Price Index (CPI). The index is compiled by The Office of National Statistics (ONS) who measure the total cost of price changes in the goods and services the average household buys each month. It's made up of around 700 items which are fixed for 12 months so changes in the overall cost can be measured. The list is updated annually to reflect changes in our buying habits - for example in 2015, chilled pizza replaced frozen pizza and sweet potato, e-cigarettes and craft beer were added 2.
The Government's inflation target
The Government's target for inflation is 2% per year 3. But why 2%? This is the rate that most central banks have adopted as it doesn't cause concern that prices are rising or falling too quickly. It also offers flexibility when the economy is weak as rates can be reduced to encourage growth without going below zero.
When inflation goes down
In April 2015, inflation actually dropped by 0.1% 4. This is the first time Britain fell into deflation for more than half a century. Prices have since bounced back but there was fear at the time that if it continued it would be harmful to the economy. The problem with deflation is it tends to reduce spending, as people hold out to make big purchases - like property - if they think prices are going to drop further.
The link between interest rates & inflation
The Bank of England adjusts interest rates to control inflation and preserve the value of our money. If economic growth is:
- slow it tends to cut interest rates to encourage people to spend and borrow more
- high it tends to increase rates to cut spending and borrowing and boost the amount people put away in savings
How inflation affects savings & mortgages
As the Bank of England adjusts interest rates to control inflation, this affects the interest rates we get on our savings and mortgages. When interest rates are low, mortgages are cheaper but you get little return on your savings. When interest rates are high, mortgages are more expensive but you make a greater return on your savings.
- Quarterly Inflation Report- November 2011, The Bank of England (PDF, 119 KB)
- Consumer Price Inflation: The 2015 Basket of Goods and Services, Office for National Statistics (PDF, 140 KB)
- Remit for the Monetary Policy Committee - March 2015, HM Treasury (PDF, 209 KB)
- Statistical bulletin: Consumer Price Inflation, April 2015, Office of National Statistics