What Is Inflation And What Causes It?

Posted by John Adam on April 18
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Inflation has been in the news this week after figures came out that showed its 12-month rate had risen from a 2-year low of 1.8% in January to 1.9% in February. You may or may not have taken much notice. It’s not a hugely exciting headline. Occasionally inflation can by more dramatic. Like when newspaper headlines scream of ‘hyper-inflation’, of the kind that has recently afflicted Venezuela.

But whether its run-of-the-mill boring old inflation of the kind we’re fortunately mainly used to in the UK or the more devastating kind that can mean from one week to the next a loaf of bread becomes possibly hundreds of times more expensive, it’s pretty important.

Central banks around the world, like the Bank of England here in the UK and Federal Reserve over in the USA, go to considerable effort to control inflation. And they’re pretty good at it. It’s something that is usually under the radar for most of us and that’s great. It’s a bit like the old adage that the best referees or umpires are those no-one talks about after the game.

Inflation is also a factor to be aware of when it comes to your investments and savings.

So what exactly is inflation, what does it affect and why can its rate go up and down, potentially spectacularly in the wrong set of circumstances?

What Is Inflation?

Most people have a good general understanding of what inflation means. It’s when things get more expensive over time. Deflation, the price of things dropping, can also happen but it’s much rarer. No matter how old we are we all remember how the same things we buy today - petrol, a pint of milk, a beer in the pub, a bus or train ticket etc., used to be cheaper.

The reason these things are more expensive today than when we were 10, 15 or 20 is inflation. When the ‘rate of inflation’ is talked about it refers to an average of lots of the things that we buy day-to-day, week-to-week and month-to-month. There are different ways to measure inflation. In the UK, there are three:

  • the consumer prices index (CPI)
  • consumer prices index including owner-occupiers’ housing costs (CPIH)
  • the retail prices index (RPI)

CPI is the official inflation rate usually quoted. It’s based on a ‘basket’ of goods and services the average person has to pay for such as basic household good and transport. CPIH includes things like council tax and RPI also includes factors such as benefits, pensions and tax allowances but is considered to have weaknesses and is generally no longer considered an accurate measure of living expenses.

What Causes Inflation?

There are three main causes of inflation:

Supply and Demand: the biggest influence on inflation is the basic principle of supply and demand. When people are prepared to pay more for goods and services, their price rises when sellers realise that. Demand tends to rise because more people can afford something or more of it. Or are prepared to pay more because supply is limited and doing so means they can afford it and others can’t.

If there’s lots of supply on the market sellers have to drop their prices to shift it by enticing more buyers.

Consumer Confidence: this is related to demand. If consumers have confidence in the economy and their future income they are more likely to loosen the purse strings which increases demand, driving up prices.

Currency Exchange Rates: if the value of a country’s currency changes compared to other currencies this can also lead to inflation or deflation because it will affect the cost of imports. We’ve seen this in the UK following the Brexit referendum.

Why Is Inflation Important To My Savings And Investment?

Inflation is important when it comes to savings and investments because if the rate is higher than the interest rate you receive on savings, your money loses value over time. That has been the case over recent years. Investments are less affected by inflation as the companies you own shares in usually increase the price of their goods or services along with inflation, balancing things out.

 

Photo - Adi Goldstein

Written by John Adam

John has almost 10 years of experience as a writer and editor on consumer finance and investment topics. An entrepreneur, he has one successful exit behind him and currently writes and consults freelance while enthusiastically pursuing hobbies he's not very good at such as football, squash and raising a small child.

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