Q&A: Inflation explained
- 2 December 2014
- From the section Business
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?
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?
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.