The Cost of Living Crisis is at the forefront of people’s minds now more than ever. With prices rising faster than they have done for 40 years as the current rate of inflation hits 10.1%, it’s unsurprising that the current economic situation is putting such a strain on UK households as they try to sustain their daily lives and keep on their heads above water with finances.
Furthermore, without government intervention, British households are set to see their spending power cut by an average of £3,000 this year, potentially pushing a further 3 million individuals into poverty.
One of the main reasons inflation is so high is because of the conflict between Russia and Ukraine that has increased gas prices dramatically. Higher prices for commodities have pushed inflation well above the inflation target of 2%. But what does that mean for the UK, and will inflation fall soon?
In this article, we’ll cover all you need to know about inflation, including its causes, what high inflation rates mean, how inflation is measured, and how to protect your finances while inflation is high. So, let’s jump in!
What is inflation?
Simply put, inflation is the increase in the price of something over time. You’ll have likely noticed this in supermarkets when you’ve done your weekly food shops, realising it’s more expensive than it used to be. And many of us will also think back to the shock of the Freddo chocolate bar no longer being five pence — yes, that’s caused by inflation too.
Inflation can also be identified and defined by the decline of purchasing power. This is the value of a currency expressed by the number of goods or services a unit of money can buy. As inflation increases, purchasing power decreases due to rising prices, reducing the number of goods and services that can be bought.
What’s the difference between inflation and deflation?
Inflation is the increase in the price of goods and services over time, while deflation is the decline in prices. While the latter may seem beneficial, both inflation and deflation can cause issues for the economy. If it persists, deflation can signal the start of a recession.
Deflation is caused by a surplus of goods and services and a lack of money in circulation to purchase them. This causes manufacturers and companies to drop prices. A basic example of how this may work is if a specific model of games console becomes popular, other companies are going to make other similar consoles to compete. This can then lead to the companies having more consoles than they can sell, therefore they will cut costs by dropping prices and laying off employees. If enough companies face this issue, it can snowball into a trend that causes deflation.
What causes inflation?
Currently, the main causes of inflation are the aftermath of the pandemic and the conflict between Russia and Ukraine. As lockdown was eased, people flocked to the shops to spend their money, and the demand for certain goods and services reached an all-time high, resulting in labour shortages and a lack of supplies. Furthermore, the conflict in Ukraine has caused supply chain issues with commodities such as crops and oil.
However, there are five main causes of inflation that may have contributed:
- Demand-Pull Inflation
- Cost-Push Inflation
- Increased supply of money
- Devaluation
- Rising wages
Demand-Pull Inflation
Demand-pull inflation happens when the supply of money and credit in a country increases, encouraging people to spend on goods and services. However, when the economy cannot meet the demands for goods and services, and it stays high, supplies are depleted, and prices increase — this then causes inflation.
For example, when the pandemic hit, medical supplies such as face masks could not be replenished quickly enough, driving prices through the roof as individuals and companies bought the remaining supplies. Seeing as these goods were a necessity for many, buyer power decreased and caused inflation.
Cost-Push Inflation
Cost-push inflation is caused by the cost of wages and production increasing. This is then filtered down to consumers in the form of increased prices for finished products. If enough businesses are affected by the cost of supplies, this can lead to a larger scale price increase and, therefore, higher inflation rates.
Increased supply of money
The supply of money is the total amount of currency in circulation, including cash, coins, and bank balances in a country. An increase in the supply of money is authorised by the monetary authorities and can be done by:
- Printing more money and supplying it to the public
- Legally devaluing the legal tender
- Loaning new money into circulation from reserve account credits by purchasing government bonds from secondary market banks.
All these methods cause money to lose its purchasing power and therefore increase inflation.
Devaluation
Devaluation is when a currency loses value compared to other currencies. This usually results in imports becoming more expensive, and therefore inflation rates increase.
For example, in 2008, the UK Pound Sterling lost 25% of its value, which caused inflation to rise above the target of 2% to 5%. This happened at the same time oil prices rose, which further contributed to the economic struggles that caused inflation.
Rising wages
There is some debate as to whether rising wages affect inflation. Some argue that increasing employee salaries will result in businesses raising prices to cover the costs of labour and production, causing inflation rates to rise. However, others state that inflation is not affected by minimum wage increases as employers may higher fewer workers or productivity levels may increase.
How do you measure inflation?
Inflation is a measure of how much the price of goods and services has increased over time. To work out the inflation rate, you’d usually calculate the difference between the current price in comparison to the year before using a price index. The average increase in prices is the inflation rate, and it’s shown as a percentage. Therefore, mathematically the equation is:
Percent Inflation Rate = (Final CPI Index Value/Initial CPI Value) x 100
The most commonly used index is the Consumer Price Index (CPI). From this, you would identify the corresponding CPI figures for the dates you are comparing and put them into the equation.
Who measures the UK’s inflation rate?
In order to identify the rate of inflation, the Office for National Statistics (ONS) tracks the prices of around 700 everyday items, which are referred to as the ‘shopping basket’ or ‘basket of goods’. This is then used to create the Consumer Price Index (CPI), which is a weighted average of the prices of the ‘basket of goods’. The CPI shows how the prices of goods and services have risen or fallen in comparison to the previous year.
Who benefits from inflation?
While inflation impacts the economy and most households negatively, some may actually benefit from price increases, including:
- Fixed-rate borrowers: those who have a fixed-rate mortgage will benefit from inflation as their loan will not be affected as prices rise. Furthermore, they’ll pay the same amount in instalments, but it’s worth less. This means that the loan amount will actually decrease as a result of the currency being devalued. Businesses that have loans with fixed interest rates will also benefit from inflation as they can take advantage of the stability and raise prices in alignment with rising prices. They can then use the extra revenue to cover loan repayments.
- Equity and commodity investors: having money in stocks or commodities is better than keeping cash during a time of high inflation. This is especially true of commodities like gold as they don’t lose value as a result of inflation.
- Landowners and property investors: the value of land and property can increase massively during high inflation as it usually ends up in short supply. Also, when inflation is high, many move to buy property as it retains its value. During inflation, the housing market is great for investors as it provides a steady stream of income, helping them overcome the effects of inflation.
How high is inflation?
The current inflation rate is 10.1% which is well above the target of 2%. Due to the soaring gas prices, which have doubled since May, inflation is still likely to be pushed higher — it’s expected to reach 13% within the next few months.
Will inflation come down?
The Bank of England previously expected inflation to fall next year as they claimed it was unlikely that energy prices will continue to rise as quickly as they have done in the last year. Furthermore, they also expected that production difficulty will diminish over the coming months, and lower demand for goods and services will cause prices to decrease.
However, lower inflation rates can take some time to hit, particularly after such a high peak. For this reason, it is likely to take around two years to reach the inflation target of 2%.
How do you protect your finances from inflation?
Inflation can have a negative effect on your finances, particularly as goods and services become more expensive. There are, however, ways to protect yourself from the impact of inflation:
- Invest in the stock market: One way to help overcome inflation is to invest in stocks, as there is the potential for good returns if you invest wisely. This said, there is the risk of losing money if an investment falls through, so ensure you can afford to invest and do your research before committing.
- Diversify your portfolio: don’t put all your eggs in one basket, as the saying goes. If you are investing in stocks, you can protect your assets by diversifying your portfolio with a variety of stocks and other assets. This will help ensure you’re not stung too badly if one investment does not work out.
- Make the move to a high-interest savings account: it may seem logical to keep your savings in a normal bank account, but if inflation rates are high, your money will actually be losing value while it sits in the account. To help overcome this, switch to an account with a high-interest rate. It may not cover the entire amount you have lost due to inflation, but you won’t lose as much value as you would if you keep your money in a standard account. It’s worth comparing interest rates to get the most out of the move.
Summary
There are several factors that cause inflation, however, the main ones are:
- Demand-Pull Inflation
- Cost-Push Inflation
- Increased supply of money
- Devaluation
- Rising wages
Currently, the main reason for inflation in the UK is the conflict between Russia and Ukraine that has caused gas prices to soar. Additionally, there have been supply-chain issues that have also caused steep price increases that have made the cost of living more expensive.
Prior to the invasion of Ukraine, the UK was hit by the pandemic, which created demand-pull inflation as the supply of commodities could not be met by the economy.
Finally, whilst inflation in the UK is set to increase to 13% later this year, it is suggested that it will return to its target rate of 2% in around two years as the production difficulties are overcome, and there is lower demand for goods and services.