What is inflation and how does it affect consumers?

What can you buy for your cash?

We read daily in the headlines that we’re facing a cost of living crisis, and many of us have noticed that everyday items are rising.

Pasta prices rose at a rate of 60% in the UK in the year to September, according to the UK Office of National Statistics (ONS), for example, and prices of other everyday essentials also soared. And such jumps in costs are being felt all over the world, with inflation rates higher than those seen for several decades.

But what is inflation, how is it calculated and what can be done about it?

Inflation is the term used to describe the rate at which prices increase.

Rising prices mean your money buys you less in the future than it does today.

It’s in the headlines at the moment because prices are soaring around the world. Global inflation will peak at 9.5% this year, up from 4.7% in 2021, but remain high at 6.5% in 2023, before falling to 4.1% in 2024, the International Monetary Fund predicts.

And that means we all have less to spend.

Inflation is calculated using what’s known as a ‘basket’ of goods that includes everyday items and monitors how they are evolving from month to month and year to year.

Statistics authorities around the world collate the prices of things you buy like auto fuel, fruit, streaming fees and visits to the doctor or dentist and use them to calculate a rate.

In the US, this basket includes gasoline, motor oil, food and health service costs. While in the UK, the basket contains more than 700 items and services and includes a loaf of bread and a bus ticket, as well as a car.

Prices of these items are used to make a “consumer price index” and the change in the price level of this index is the rate of inflation.

What to include in the basket and the best approach to measuring inflation is under debate, as outlined here by the ONS.

At the moment, prices in many countries are rising too fast, with rates in many developed countries at multi-year highs.

Inflation in the US was more than 8% in September compared with a year earlier and 10.1% in the UK. That compares with the roughly 2% that most policymakers accept is a stable rate.

Many central banks, including the Federal Reserve, the European Central Bank and the Bank of England, have explicit targets to keep the rate around 2%.

Monetary policy is the term used to describe the tools that central banks use to keep inflation low and stable.

Interest rates are the key tool in achieving this, with the theory being that a higher benchmark rate set by the central bank makes it more costly for banks, consumers and businesses to borrow money. This means they are likely to spend less, which reduces demand.

Lower demand makes it harder for companies to increase prices and that lowers the rate of inflation.

Market interest rates - or the rate you are likely to pay on a loan - are linked to the key rate of the central bank.

Fiscal, or government policy can also influence inflation, which includes policies aimed at increasing the efficiency of the economy. This should bring down long-term costs, raising income tax with the aim of reducing spending, and trying to keep a lid on wages, to damp risks of a wage-price spiral.

The difficulty is that many economies are influenced by factors outside the control of the government or central bank. Prices of food and energy are often volatile and influenced by global factors.

Russia’s invasion of Ukraine resulted in disrupted and halted Russian gas supply to Europe, which pushed UK gas prices up 96% in the year to September 2022. And that’s a factor outside the control of the UK authorities.

So, when it comes to inflation, there are some things we can try to control and some things we can’t.

What’s clear is that price pressures are persisting more than most of us – including the experts – anticipated, making everyone’s costs soar, and it is something we are all going to have to manage in the next couple of years.