Q&A: Inflation explained

Receipt and coins

Inflation is one of the most important issues in economics.

It influences the interest rate we get on our savings and the rate we pay on our mortgages.

Inflation also affects the level of pensions and benefits, as well as the price of some train tickets.

What is inflation?

Inflation is the rate of increase in prices for goods and services.

There are a number of different measures of inflation in use. The most frequently quoted and most significant ones are the Consumer Prices Index (CPI) and the Retail Prices Index (RPI).

Each looks at the prices of hundreds of things we commonly spend money on, including bread, cinema tickets and pints of beer - and tracks how these prices have changed over time.

The inflation rates are expressed as percentages. If CPI is 3%, this means that on average, the price of products and services we buy is 3% higher than a year earlier.

Or, in other words, we would need to spend 3% more to buy the same things we bought 12 months ago.

RPI includes housing costs such as mortgage interest payments and council tax, whereas CPI does not.

But that only accounts for a small part of the difference between RPI and CPI.

The main difference is caused by the fact that, although they use much of the same data, they calculate the inflation rate using different formulae.

The one CPI uses takes into account that when prices rise, some people will switch to products that have gone up by less.

This results in a lower CPI reading than RPI in nearly all cases.

The method used to calculate RPI is no longer considered as best practice so it has had its national statistic status removed, although the Office for National Statistics (ONS) still calculates it every month.

Why is it important?
Shopper and basket Researchers track the prices of thousands of items we regularly put in our shopping baskets

The data from the CPI and RPI rates are used in many ways by the government and businesses, and play an important role in setting economic policy.

That's because the Bank of England uses inflation to set interest rates. If the Bank's Monetary Policy Committee thinks CPI inflation will be above 2% in the next two years or so, it may increase interest rates to try to subdue it.

Conversely if it thinks inflation is likely to be below 2%, it may cut interest rates.

That's why inflation is a crucial factor in determining the rates banks charge for mortgages and the rates they offer on savings accounts.

It also has a direct impact on some people's incomes.

Anything that is described as index-linked rises in line with inflation, usually as measured by the CPI or the RPI.

State benefits and many occupational pensions rise in line with CPI. Government index-linked savings products and some train ticket prices rise in line with RPI.

The basic state pension is currently governed by the so-called triple-lock, rising by the highest of CPI, average earnings or 2.5%.

Some companies use the level of inflation to set annual pay rises. In recent years however, due to the effects of the recession, many pay settlements have fallen behind price rises.

How is inflation calculated?

INFLATION CALCULATOR

Detail from inflation calculator

Every month the ONS collects more than 100,000 prices of goods and services from a wide range of retailers across the country - including online retailers.

Prices are updated every month and price collectors visit the same retailers each time in order to monitor identical goods and make sure they are comparing like with like.

All these prices are combined using information on average household spending patterns to produce an overall prices index.

It also takes into account how much we spend on different items.

So items are weighted - i.e. given more importance in the inflation indexes - according to how much we spend on them.

We typically spend more on fuel than on postage stamps, for example.

So a large rise in the price of petrol and diesel would affect the overall rate of inflation more, as it has a weight of 3.5% in the CPI.

Meanwhile a rise in the price of stamps is less likely to affect the overall index, as they have a weighting of 0.2%.

This guide was compiled with information from the ONS.

More on This Story

The BBC is not responsible for the content of external Internet sites

More Business stories

RSS

Business Live

  1.  
    09:10: Facebook friends Russia
    Navalny

    On its front page, The Independent reports that Facebook has been accused of giving in to censorship after it apparently blocked access to a protest page on its site - under pressure from the Kremlin. A former US ambassador to Russia describes it as a "horrible precedent". According to The Daily Telegraph, Facebook has declined to comment on the suggestion that it stopped Russian users from viewing a page, rallying support for one of President Putin's most prominent opponents.

     
  2.  
    08:55: UK jobs Radio 5 live

    The employers' organisation, the CBI, says its latest survey suggests that half of its members plan to take on more staff next year. "Skills are at a premium in lots of areas," says CBI's director for employment and skills, Neil Carberry. "In fact one of the things we found in this year's survey is the biggest worry now for companies in their broadly rosy picture is whether they can get the skills they need to keep growing."

     
  3.  
    08:45: Markets update

    The main European markets are all looking rather chirpy this morning. Gains for oil firms, including Tullow Oil, Royal Dutch Shell and BP are driving the FTSE up 1% to 6,608. That's partly because Brent Crude has risen by 2% to $62.24 a barrel. In Germany, the Dax is up 0.9% to 9872, while in France, the Cac-40 is up 1.2% to 4293.

     
  4.  
    Cranking up Lada 08:28: Via Email Tony Higgins Lada owner

    "We had a Lada Niva. We bought it when we moved to a Lancashire hill farm in 1993. It was great. The early years were bad winters but the Lada coped very well. It was like a crab both on and off road, permanent 4WD. No power steering so hard work."

     
  5.  
    08:12: Pull over, Uber
    Xiaomi

    Uber may have been valued at $40bn, but one Chinese tech firm could now be worth an estimated $45bn, despite being relatively unknown outside Asia. The WSJ reports that smartphone and tablet maker Xiaomi, whose polished branding and devoted fan base is reminiscent of Apple's, has overtaken Samsung in China, but faces several challenges in expanding into India and beyond.

     
  6.  
    07:54: Cranking up Lada

    So, on to some of those Lada jokes. What do you call a Lada with a sun roof? A skip. What do you call a Lada with a sunroof and twin exhausts? A wheelbarrow. Etc. Send us your favourite Lada jokes: bizlivepage@bbc.co.uk and we will publish the best. Or if you've driven a Lada, and think they get a bad rap, let us know.

     
  7.  
    07:49: Cranking up Lada
    Lada

    The New York Times reports that the Kremlin is seeking to revive Russia's last major Soviet brand - the carmaker Lada. It has recruited Swedish-American Bo Inge Andersson, previously a vice president at General Motors. Lada, historically the butt of many jokes, still accounts for a third of all cars in Russia, and as foreign companies like Audi and Jaguar Land Rover suspend sales in the country due to the plummeting rouble, the utilitarian company could return to strength.

     
  8.  
    07:35: B&Q China
    bnq

    Kingfisher says it will flog its controlling 70% stake in B&Q China to Wumei Holdings for £140m. It opened its first B&Q in the country in 1999.

     
  9.  
    07:25: Oil blessing?

    The Guardian's leader takes a contrarian stance on falling oil prices, which have been widely welcomed by Western consumers. "Oil has dipped 40%, pessimists fear, because the world no longer expects a return to economic full pelt," it argues. "Europe, Japan and - relative to its own vigorous standards - China, have all been looking anaemic this year. Like low blood pressure after a heart attack, then, cheap oil should arguably be regarded not as a sign of rude health, but rather as a consequence of malaise."

     
  10.  
    07:12: Budget Samsung
    Samsung

    $100 for a Samsung smartphone? CNBC reports the South Korean company is entering the increasingly competitive budget handset market, in a bid to sell more phones in India, where many people still use simple phones. The new handset will run Samsung's own Tizen software.

     
  11.  
    06:58: Rates Radio 5 live

    The Bank of England's Martin Weale adds that he is optimistic about the year ahead. More money to spend from cheaper oil will help. He's on the committee that helps decide the key interest rate. Will it rise this year? He's careful not to second-guess his colleagues on that one.

     
  12.  
    06:46: Santa rally? Radio 5 live
    santa

    Will there be a so-called Santa rally this year? A rise in markets in the days around Christmas? Brenda Kelly from IG says you see one in almost nine out of every 10 years since the '80s.

     
  13.  
    06:28: Rates Radio 5 live

    The Bank of England's Martin Weale has been telling Wake Up to Money why he's been voting for interest rates to move off the record low of 0.5%. "It isn't only that unemployment has been falling - at least until recently extremely rapidly. It's also that when I go and visit businesses throughout the country I find they're talking of pay increases in a way quite different from what I was hearing early in the year certainly this time last year."

     
  14.  
    06:16: Markets Radio 5 live

    Brenda Kelly from IG is Wake Up to Money's markets guest. They are talking about the falling oil prices. "A lot of it is down to a glut of supply and Saudi Arabia wants to keep market share," she says. Saudi's breakeven price is only a few dollars per barrel.

     
  15.  
    06:10: Christmas spending Radio 5 live

    Mark Barnett, UK & Ireland president of Mastercard, is on Wake Up to Money, talking about Christmas shopping habits. What else? People have returned to luxury goods, he said. Holidays and furniture are down a little bit though.

     
  16.  
    06:04: Hacking 2.0
    Kim Jong

    The global cyberwar that dominated headlines last week shows no signs of abating. Hackers have infiltrated South Korea's nuclear power provider, and posted schematics of nuclear reactors and private personal records online. It's not clear whether the same group that attacked Sony Pictures is responsible.

     
  17.  
    06:00: Howard Mustoe Business reporter

    Morning! Get in touch. Tell us what you think. Email bizlivepage@bbc.co.uk or on Twitter @BBCBusiness

     
  18.  
    06:00: Joe Miller Business Reporter

    Good morning, and festive greetings all round. In a week when the business world is winding down for Christmas, we'll bring you all the news that's sneaking in the back door, and much more besides.

     

Features

From BBC Capital

Programmes

  • (File photo) A man dressed as Father Christmas with a sleigh and a reindeer Click Watch

    A website which tracks Father Christmas, plus other sites and apps to keep you entertained

BBC © 2014 The BBC is not responsible for the content of external sites. Read more.

This page is best viewed in an up-to-date web browser with style sheets (CSS) enabled. While you will be able to view the content of this page in your current browser, you will not be able to get the full visual experience. Please consider upgrading your browser software or enabling style sheets (CSS) if you are able to do so.