Jane Charlesworth: What you need to know about inflation

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Over the past few months, we’ve seen lots of speculation about inflation rates changing and what this might mean for consumers. Now, those hypothetical changes are becoming a reality with the falling pound and rising prices grabbing national headlines.

But what exactly is inflation?  And perhaps more importantly, what does it mean for local families and businesses?

What is inflation?

In simple terms, inflation is the rate of increase or decrease in prices in an economy – although falling prices would usually be referred to as deflation.

How is it measured?

Economists and business analysts measure inflation by comparing the present price of a ‘basket’ of goods and services to its price on a previous occasion – for example, how much did this basket cost in the same month a year ago?

The most commonly reported measure is consumer price inflation (the UK’s official inflation rate is measured by the consumer price index, or CPI), which uses a basket of a very large range of goods and services regularly bought by households to measure how our purchasing power is affected as prices go up and down.

For example, the Bank of England might have an expected inflation rate of, say, 2 per cent, which means that if the ‘basket’ cost £100 last year it is expected to cost £102 at the same time this year.  If the rate of inflation is higher than that, for example 3 percent, it means that prices are going up at a faster rate than expected and the basket would cost us £103.

So if inflation falls, will prices go down?

Sadly not. If the rate of inflation fell to 1 per cent, then prices are still going up overall but not as rapidly as before. A negative rate of inflation (or deflation, as it’s sometimes known) would indicate falling prices.

Because inflation is usually calculated year on year, a rise (or fall) in the price of a certain type of goods in one month will influence the inflation figures for the following year. For example, if the price of petrol between September 2014 and August 2015 was £1 per litre, and then in September 2015 it increased to £1.05 per litre, the rate of petrol price inflation in September 2015 would be 5 per cent.  It will remain at 5 per cent as long as there are no further price changes until September 2016 when it would drop to 0%.  Although the price of petrol has not changed in that month, the inflation figures are affected by the previous year’s price increase ‘dropping out’ of the calculation.

Why does inflation go up?

This comes down to supply and demand. If there is an increase in demand for goods and services which rises more rapidly than a firm’s ability to produce them, prices are likely to rise more rapidly.

And there’s a knock-on effect; an increase in firms’ costs such as higher prices for oil, would increase transport costs, energy costs, raw material costs.

Related to this is the exchange rate. If this falls – so the pound has a lower value compared with other currencies – the products a company exports will be cheaper and things that are imported will become more expensive. So retailers might charge more for their goods to meet their overheads.

What does the change mean for consumers and businesses?

On their own, the latest inflation figures do not appear to be indicative of a significant change in economic conditions. In fact, they appear to reflect changes in timing of normal price increases, such as clothing, and the effect of falling fuel prices last year no longer affecting the current inflation figures.

That said, they probably do also reflect that the recovery from the last recession has been going on for some time and the economy is probably operating at close to full capacity, so increases in demand are more likely to lead to price rises. The inflation we are currently seeing is in all probability a precursor to further rises in the rate of inflation resulting from the continued fall in the value of the pound.

Companies will have insured against currency fluctuations in the short run, so the fall in the pound’s value does not appear to have had a significant impact yet – but there is emphasis on that “yet”. Over the course of the next year we should expect to see the depreciation of our currency cause the rate of inflation to increase further. As consumers, this is likely to affect us particularly when buying goods such as petrol, food and groceries, where the fall in the value of the pound against the US dollar and Euro will be particularly significant.

Jane Charlesworth is a Senior Lecturer at Lincoln International Business School, University of Lincoln.