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Understanding inflation – A consumers’ guide
By Becca Talbot becca.talbot@consumerchoices.co.ukThe rising costs of petrol, food and heating our homes have driven inflation to a 16 year high in recent months, and for some of us – most notably the elderly – the cost of living has been rising at an alarming rate.
Earlier this month (October 2008), the Office for National Statistics (ONS) published consumer price inflation figures, which show that inflation has continued to climb past September’s high of 5.2%.
But what exactly does a rise in inflation mean, and how does it affect us as consumers? How is inflation calculated, and more importantly, how can you avoid the rising costs? This CreditChoices.co.uk guide will tell you everything you need to know about inflation.
- What is inflation?
- How is inflation calculated?
- What causes inflation?
- What does inflation mean to you?
- How to beat rising inflation
- Our Recommendations
What is inflation?
Very simply, inflation is the increase in the cost of living, as a result of a general rise in prices. The inflation rate is calculated by monitoring changes in the prices of a specific range of different products and services selected to represent average spending patterns in the UK (often referred to as the “basket of goods”).
The Office for National Statistics (ONS) monitors changes in these prices each month, and uses this to work out an average increase for the year. The different items in the basket of goods are given different “weights,” so that the habitual things we spend more on - like housing, travel and food – influence price rises more than less frequently purchased items, such as plasma TVs or digital cameras.
A simple example to show how inflation affects us is by looking at the increase in food prices: In 1988, two pints of milk cost 52p. Nowadays, 20 years later, the same two pints would cost 86p (Tesco October 2008).
How is inflation calculated?
Each month the ONS collects the prices of 120,000 products and services from a wide range of retailers across the country, ensuring that its indexes accurately reflect price variations throughout the UK.
Prices are updated monthly, and price collectors visit the same retailers each time in order to monitor identical goods, to make sure they compare like with like. The prices are then combined using information on average household spending patterns to produce an overall prices index, called the Consumer Price Index (CPI). The percentage change in the CPI year on year is then used as a measure of inflation.
The Consumer Price Index forms the basis for the Government’s inflation targets each year; which the Bank of England’s Monetary Policy Committee is required to achieve. The CPI was developed according to internationally agreed rules, and is known globally as the HICP, which is used for international comparisons of inflation.
To keep the CPI up with general spending patterns, the ONS revises which products and services it collects prices on each year, and what weight it gives them. A review in 2002 for example, added DVD players, hair dye, frozen vegetarian ready meals and cable telephone charges to the list, but took off loose tea, pipe tobacco, shower curtains and credit card charges.
The diagram below shows the average components of the Consumer Price Index (“basket of goods”):
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The various categories cover a wide range of products and services. For example, the housing sector includes rent, mortgage interest payments, depreciation, council tax and water rates; whilst household goods includes domestic energy usage, as well as telephone bills and broadband subscriptions.
A single price change on just one item could affect the whole CPI. For instance, a large rise in the price of petrol and diesel, could affect the overall rate of inflation since it has a larger segment (4%) of the CPI, more so than a rise in postage charges could, because they have a much smaller segment (0.1%). The segment size is calculated depending on the quantity and frequency of money spent on a particular product or service.
What causes inflation?
One cause of inflation is the level of monetary demand in the economy - how much money is being spent.
A good illustration to demonstrate this would be when prices of some products rise, such as the price of oil. Oil prices may rise for example, if there is a war or an event that means supply is limited. If consumer demand for oil stays at the same amount, they will now have to spend more, because the price of oil has risen. This is only possible if their incomes are also rising, or if they are prepared to spend a bigger proportion of their incomes and save less.
This process does take time, and prices won’t fluctuate that dramatically. The economic situation becomes complicated if incomes are affected by the rise and falls in prices - maybe because lower import prices cause firms competing with imports to lose sales and reduce the number of people they employ – however this example shows the basics of inflation, and how it is dependent on the amount of demand in the economy.
What does inflation mean to you?
Rising inflation and prices will cause the cost of living to increase inexorably. Because many goods are essentials, that we buy habitually, like bread and milk, if the price of these go up consumers will have less money to spend on more expensive items. This means the standard of living will decrease.
For example, when oil prices rise (because demand is high and supply is limited), inflations can have a dramatic effect on us as consumers. Petrol prises will increase, energy prices will increase, and ultimately, food prices will increase. As the cost of grain rockets, because the machinery used to plant and harvest it becomes more expensive, the cost of other items that are made from grain (or flour) also rise, for example pasta, bread and cakes. The price of meat will also rise (as livestock feeds on grain) so the cost of farming will consequently increase. The impact of inflation on consumers is evident in most areas.
However, one of the key factors that impacts consumers is interest rates. According to research from National Savings and Investments (NS&I), many UK savers are still suffering from a lack of knowledge as to the effects of inflation on their savings when choosing the right account for their money, despite wide coverage of the credit crunch and its implications.
The government-backed savings and investments organisation found that almost a third of people said that although they know what inflation is they don’t understand how it affects their savings while almost one in ten said they don’t know what inflation is at all.
So what exactly does inflation mean to you as a consumer, and how does it affect your life? Well, when we talk about inflation going up, it is usually the CPI we are referring to.
CPI acts primarily as an economic measure and it is the Bank of England’s job to keep it at 2%. If it rises, as it has recently, then the bank could be forced to increase interest rates to bring it down to reduce demand and reduce inflation. This is where inflation becomes important to everyone; if headlines say inflation is up, then it is likely that the Bank of England will increase interest rates, meaning the cost of a loan or a mortgage is likely to go up.
High inflation will also affect saving and investments. For example, if you put £100 in the bank at an interest rate of 5%, after a year you'll have £105. However, if inflation is at five per cent then the purchasing power of that £105 would be the same as £100 a year a go. This is because in that year the cost of goods has risen by as much as the investment.
If UK investments and savings accounts don’t seem attractive, then there is pressure on the Bank of England and the government to sort out inflation, so big investors don’t look to put their money overseas.
How to beat rising inflation
While avoiding inflation completely is impossible, there are several things you can do to help minimise the impact of the cost of rising inflation from affecting your life. Here are just a few ideas:
- Take advantage of an ISA - A cash individual savings account (ISA) works like any other standard deposit account; however the interest gained in an ISA is tax-free, which effectively boosts the income from those savings. You can invest up to £3,600 a year in a cash ISA.
Read our article to get the low-down on ISAs and how they can help you get the most from your savings. Then compare ISAs online with our savings account comparison tool.
- Shop for your shopping – Online supermarket MySupermarket.co.uk is a useful website which can help you compare prices on products from four of the leading supermarkets. Just fill your cyber trolley with everything you need to fill your fridge, and then click ‘checkout’ – they’ll calculate how much you can save by buying your goodies from other shops, helping you find the best deals.
- Switch to a better deal – Home services such as phone and broadband are two costs that luckily have fallen over the last couple of years, so it makes sense to switch to better deal if it can save you money.
Households which took out separate home phone, broadband and TV packages several years ago, and who have never switched, could potentially save hundreds of pounds by moving to a bundled deal. BroadbandChoices.co.uk estimates that the average household could save £135 a year by bundling all three services.
- Boost your income with a bond – Take home pay may not go up much in the next few years, but if you take out an index-linked bond you’re guaranteed that your investment will rise at the same rate as the cost of living. NS&I offer two index-linked bond products. Visit their website for more information.
- Look out for our money saving and money making tips – We have several articles that offer ideas on how to make money quickly, save money on your motoring and boost your savings.
Our Recommendations
CreditChoices.co.uk suggests using the ONS inflation calculator to see how your inflation rate compares to the UK average. The calculator allows you to put in an estimate of how much you spend on a range of products and services. Then, using a range of national average price changes, it will give you an indication of how your household inflation differs from the national rate.
Unfortunately the calculator won’t give you an exact measure of your inflation rate, and price changes will vary according to a number of factors (such as where you buy your groceries, which precise brands you buy and where you live); but it will give you an indication of how the inflation you experience is affected by what you spend your money on.
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