Getting to grips with . . .

Why does inflation matter?

Prices are rising faster than they have for four decades, putting pressure on household budgets

Inflation in the UK has reached its highest level in four decades as prices rise by 9% a year.

The Bank of England (BoE) has raised its inflation forecast for the fifth time in seven months, and now predicts it will hit 11% this autumn, when energy bills rise.

The Monetary Policy Committee of the BoE – which sets interest rates – has warned that inflation is likely to peak at “slightly above 11% in October” before falling next year, with the price of food and fuel putting pressure on household budgets. Only last month it had predicted a peak of 10%.

When inflation hit 7% in March, BoE governor Andrew Bailey warned that an “apocalyptic” rise in global food prices was likely to have more of an effect on households than rising interest rates, as he sought to defend the bank from criticism by government ministers that it had not done enough to “rein in rising prices”, said the BBC

But with inflation set to rise even further, it is a long way from the BoE’s mandated 2% target.

What is inflation and how is it measured? 

Inflation is a measure of the rate at which a range of prices rise over a given period of time.

In the UK, inflation is measured by the Office for National Statistics (ONS), which notes the prices of 700 everyday items known as the “basket of goods”. 

The basket of goods is “constantly updated”, said the BBC, with items such as tinned beans and sports bras added in 2022, to reflect a “rising interest in plant-based diets and exercise”.

The price of that basket “tells us the overall price level”, known as the Consumer Prices Index (CPI), explained the Bank of England’s website. 

To calculate the rate of inflation, the cost of the basket – the level of CPI – is compared with the price of the basket on the same date last year. The change in the price level over the year is the rate of inflation.

Why is inflation so high right now?

Britain's official rate of inflation hit a 40-year high of 9% in April and is forecast to surpass 11% later in 2022. It has risen for a number of reasons, according to the BoE.

In part, the UK is struggling with runway prices because “it has been hit by a series of external shocks”, said ITV. Prices have risen because of the difficulties in getting goods to customers as economies around the world recover from the Covid-19 pandemic. This has pushed up the price of products, especially for goods coming from abroad.

The Russian invasion of Ukraine has also led to a large increase in the price of energy and food. Lockdowns in China, which is still pursuing a policy of zero-Covid, also means it is harder to import some goods into the UK.

But, as the governor of the BoE pointed out in a letter to the chancellor this week: “Not all of the excess inflation can be attributed to global events.”

The Bank’s concern is that there are signs that inflation is starting to be generated domestically in the UK – that companies are raising their prices and workers are asking for higher wages, which in turn leads to higher costs in the service sector.

But not everyone is seeing an increase in their pay packet. In fact, average wages are now in decline. The ONS said annual growth in regular pay, excluding bonuses, fell by 4.5% in April after adjusting for inflation – the biggest fall since comparable records began in 2001.

What can be done to tackle inflation?

The “Goldilocks and the Three Bears analogy” is a useful tool when trying to understand why inflation is important, said HuffPost. If inflation is too low, then economic growth is “cold” and the economy won’t grow. Too high, and the economy is too “hot” and will grow too quickly – leading to rocketing prices. 

“Much like that third bowl of porridge” the ideal inflation rate is around 2%, keeping inflation low and stable, which is “just right” for the economy. 

The BoE’s “traditional response” to rising inflation is to raise interest rates, said the BBC. While this can benefit savers, it means that “some people with mortgages see their monthly payments go up”.

However, because much of the UK’s current inflation is caused by external factors, like rising global energy prices, “there is a limit as to how effective UK interest rate rises can be in curbing inflation”, said the broadcaster.

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