What is... | May 7, 2014

What is inflation?

Do you remember when bread cost a third of the price? Part of that price rise will be due to inflation.

Some might not like the idea of paying more, but economists consider slow, sustained inflation to be a sign of a healthy economy. One disadvantage is that inflation can make saving for the future more complicated.

How does inflation work?
Put simply, inflation is a general rise in prices. It does not mean that all prices are rising – or that they are rising at the same rate. It means that the average in an agreed, weighted basket is going up.

If the inflation rate is two percent a year this means that if your shopping costs you 100 euros today, it would only have cost you 98 euros a year ago. If inflation stays at two percent, the same basket of shopping will cost 102 euros in a year’s time. It eats away at spending power.

Central banks focus on inflation
The European Central Bank, for example, targets inflation of below but close to two percent.

In the United Kingdom, if inflation (as measured by the consumer price index, or CPI) is more than one percentage point above or below the two percent target, the Bank of England’s Monetary Policy Committee must write a letter of explanation to the Government’s Chancellor of the Exchequer.

The good side of rising prices
In some circumstances, high inflation can actually make money go further.

For borrowers with a fixed rate of interest for a long period of time (perhaps on a mortgage), inflation moving above the rate of interest effectively eats away at the debt. Especially if the borrowers’ wages keep up with inflation. Or borrowers who time the market right, might lock into low interest rates by borrowing at fixed rates – possibly being shielded from subsequent inflation rises.

And the bad
On the other hand, some of the groups who tend to be losers from high inflation are earners and savers. If inflation jumps to 7% when your pay is only rising at 5%, your spending power is declining in what is called “real terms”.

Over the long term, these small percentage differences can have serious implications. When planning for retirement, it is key to factor in the impact of years of inflation.

Think of that earlier basket of shopping. What would happen to the price in 20 years if the rate of inflation is still at two percent but your wages don't increase? The cost of the goods in the representative basket will be 49% higher in 20 years and 81% higher in 30 years. Given that many people work for 30 years or more, the effect of inflation on standards of living can be dramatic.

What if…
Even when inflation is low, you cannot afford to ignore it. Economist Chris Dillow says savers need to increase their savings to fight inflation. This can be difficult. 

This eZonomics article on beating inflation suggests looking at index-linked investments. Such arrangements can be attractive when inflation is high, less so if the inflation rate slows or turns negative.


eZonomics team
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