Personal Finance

What is inflation and why is it so high?

Inflation remains at historically high levels despite dipping slightly to 10.7% in November. 

An “easing in the rise in petrol prices” has helped lower annual inflation rates which reached 11.1% in October, said the Financial Times. The figure was “better than an expected 10.9%” rate, said the paper, adding that some economists think that the inflation rate has “now probably passed its peak”. 

Although smaller petrol price increases have contributed to a downward momentum, the Office for National Statistics (ONS) said this had been partially offset by continued sharp price rises in restaurants, cafes and pubs.

The dip in inflation will do little to help those feeling the bite of the cost-of-living crisis, as “soaring prices” see “low-income households struggle to afford basic supplies and energy bills”, said LBC. The latest figures from the ONS reveal a staggering rise in food prices, with costs rising by 16.5% from last year. 

But the fall in inflation will, however, “ease pressure” on the Bank of England (BoE) as the central bank prepares to make its latest interest rate decision, said The Telegraph.

Experts believe the bank will raise its key interest rates by half a percentage point to 3.5% – its ninth consecutive rise. But the rate rise could leave home-owners feeling the pinch, with the BoE’s Financial Stability Report predicting that the average mortgage repayments could surge by £3,000 a year.  

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 ONS, which tracks the prices of 700 everyday items known as the “basket of goods”.  

The basket of goods is “constantly updated”, said the BBC. Items including tinned beans and sports bras were 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”, or CPI, explained the Bank of England’s website.  

To calculate the rate of inflation, the cost of the basket – the level of the CPI – is compared with the cost 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 has been rising for a number of reasons, according to the BoE. 

The UK is struggling with runaway prices after being “hit by a series of external shocks”, said ITV News. Difficulties in getting goods to customers as economies worldwide recover from the pandemic has pushed up the price of products, especially for imported goods. 

The Russian invasion of Ukraine has also led to hikes in food and energy prices. 

But the governor of the BoE said in a letter to the Treasury in September that “not all of the excess inflation can be attributed to global events”. 

The Bank says inflation is starting to be generated domestically in the UK, as companies raise their prices and workers ask for higher wages, which in turn leads to higher costs. 

Wages have risen at their “fastest rate in more than 20 years” but continue to “lag well behind the soaring cost of living”, said the BBC’s business reporter Daniel Thomas. Wages rose to 5.7% in the year to September, “the fastest growth since 2000”, but in real terms, wages fell by 2.7% because of soaring inflation.   

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, 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. Although this can benefit savers, “some people with mortgages see their monthly payments go up”. 

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

Restricting prices – as with the energy price cap – to deal with “profit inflation” can also be “counterproductive”, wrote Will Dunn in The New Statesman, because it does “little to dampen demand”. 

A change to tax may be the answer, he argued, with the current system favouring “the wealth accumulated from company profits” more than “income from work”. Not dealing with this problem “could cause a longer and deeper recession” for the UK. 

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