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Inflation affects everyone, yet many people may not fully understand what it is and how it can impact their daily lives. This guide aims to provide a comprehensive overview of inflation in the UK and why it’s important to get your head around. We’ll cover different types of inflation, their causes, and why at low levels it's good for the economy. Also, we’ll provide some ways to protect yourself from negative effects of inflation.
What is Inflation and Why Should You Care?
Inflation describes how the price of goods and services changes over time. When inflation is positive - that is, more than 0% - the purchasing power of your money decreases over time. Let’s take bread as an example: as of 2022, inflation caused a 20.5% rise in prices compared to 2021. In other words, you would need to spend an additional 20.5% to get your hands on the same loaf.
Inflation is important to understand because as the prices of goods continue to rise, the real value of your money decreases. Over time, this can add up and have a significant impact on your standard of living. Therefore, it’s essential to learn and understand how to avoid the negative effects of inflation. More on that later.
The value of your money is more than the number of pounds and pence. The true value lies in what that money can buy you.
High inflation means the things you buy cost more - so that same £10 gets you less than it did before.
Inflation can have a ripple effect on other aspects of your life, such as your job and income. For instance, if companies face rising costs due to inflation, they may adjust their operating costs to maintain profitability. This could mean reducing wages, benefits, or other compensation for their employees. Also, they may lay off employees if the business is struggling to stay afloat.
How Does Inflation Affect Me?
Inflation can affect your daily life in several ways, such as:
Decreased purchasing power: Each year, your money reduces in value due to inflation, meaning you’ll be able to buy fewer goods with the same amount of money.
Increased cost of living: Inflation drives up the cost of everyday expenses like food, rent, clothes, and utilities.
Reduced savings: The value of your savings can be reduced by inflation over time, making it harder to save for the future.
Transportation costs: As fuel prices increase with inflation, travelling becomes more expensive.
Is Inflation Good for the Economy?
Now that you know inflation will reduce your purchasing power over time, you may be curious about whether inflation is solely a negative aspect of the economy. Inflation can be viewed as a double-edged sword for the economy. On one hand, a moderate amount of inflation can help economic growth by encouraging spending and investing. However, too much inflation can lead to economic instability and decrease purchasing power.
To help you understand, here are some benefits and negatives of inflation:
- Boosts economic growth by encouraging spending and investing
- Reduces unemployment by increasing demand for goods and services
- Eases the burden of debt by reducing the debt’s value over time
- Inflation prevents deflation which can cause a recession
- Supports wage growth
- Decreases the purchasing power, meaning you’ll have to spend more on goods.
- Can lead to higher interest rates
- Will cause the cost of goods and services to increase
- High inflation can lead to economic uncertainty and instability
Types of Inflation and Their Causes
Types of Inflation
There are several types of inflation caused by different factors. Some of the main types of inflation relevant to UK residents are:
Demand-Pull Inflation: This is when the demand for goods and services outweighs what can be produced, increasing prices.
Cost-Push Inflation: This occurs when labour or raw materials costs increase. As a result, the prices of goods and services cost more.
Built-In Inflation: When workers expect wages to increase as the price of goods costs more. This results in higher production costs, which in turn raises the prices of goods and services again.
Disinflation: When the inflation rate decreases, but prices of goods continue to rise.
Stagflation: This happens when inflation occurs while unemployment is rising, or there is no economic growth. The negative of this type of inflation is people’s wages reduce while the cost of goods rises.
Reflation: When the inflation cycle starts after a recession has occurred. This is a positive as it indicates a growing economy despite rising prices.
Other Causes of Inflation
Printing Money
Excess money printing in an economy typically causes inflation to rise. When the circulating money in a country surpasses its economic growth, it will reduce the value of its currency. Due to consumers having more money to spend, demand can increase faster than production, resulting in a shortage of goods. When this happens, companies may increase the prices of their goods to meet demand.
Economy
In a growing economy, wages usually increase, and unemployment decreases. This allows individuals to spend money on luxuries and services. The higher demand usually leads to manufacturers raising their prices and labour force to meet customer demand. Inflation in a growing economy is positive as long as it’s managed correctly.
National Debt
National debt can lead to rising interest rates and VAT (Value Added Tax), which causes the prices of goods to increase. A country like the UK can print more money to settle its national debt, but this will likely lead to excess cash in the economy, causing inflation.
Government Policies
The UK government can influence inflation rates by changing or creating new policies. For example, raising or lowering interest rates. The UK’s central bank uses two main monetary policies:
Bank Rate - this is the interest rate banks receive for borrowing money
Quantitative easing - this is when the Bank of England buys bonds to lower interest rates on loans and savings.
The UK’s government is targeting an annual inflation rate of 2%, which will stimulate economic growth while not reducing buying power significantly.
How You Can Protect Yourself From the Negative Effects of Inflation
The UK inflation rate reached 11.1% in October 2022, which was the largest rise in 42 years. With that in mind, it’s a great idea to do everything you can to avoid the negative effects of inflation. Some of the things you can do include:
Don’t delay major purchases: Prices will likely rise due to inflation, so it’s a good idea not to wait on major purchases on assets like a car or house.
Put savings to work: Keeping any extra money in a dedicated savings account can help to counter the impact of inflation. Achieving higher interest rates will help offset the decrease in spending power of each £. Make sure to factor in tax on savings when deciding what to do.
UK index-linked gilts: This government-issued bond adjusts to the inflation rate. Therefore, your money value over time is protected against the effects of inflation.
Maximise tax efficiency: The UK provides many schemes that will save you money on taxes. For example, pension funds will let you withdraw a lump sum once you hit retirement age tax-free. Also, if you’re an investor, you can use the capital gain tax allowance to take out profits up to £12,300.
Make investments: Investing is a great way to counter inflation as you won’t hold money that reduces in value over time. Some assets you may find interesting are stocks, bonds, savings accounts, index funds, and certificates of deposit.
Historical Trends of Inflation in the UK
Early 20th Century
In the early 20th century, the UK experienced relatively low levels of inflation until World War 1, when inflation rose from -0.4% to 12.5%. This spike in inflation was due to the UK government printing more money to fund the war effort. Afterwards, the UK experienced deflation until World War 2, when inflation rates rose again.
1970
The 1970s was a decade of high inflation, with prices rising quickly due to many factors, but mainly because of the oil crisis in 1973. This was an agreement between OAPEC nations to cut oil sales to the United States, which had a ripple effect on the price of oil worldwide. The highest inflation rate was in 1975, when inflation reached a record high of 24.2%.
Dot-Com Bubble
In the late 1990s and early 2000s, inflation began to rise due to increased global demand for goods and services. However, then the dot-com bubble burst. This was a period of speculative investments in internet-based companies. Many people were eager to get in on the ground floor of what was perceived as the next big thing. As a result, money started pouring into startups with little to no revenue or proven business model.
This surged stock prices as demand for shares of these companies outstripped supply. As time went on, it was clear that many of these companies were not sustainable and would provide no returns to investors. This led to a rapid decline in stock prices and widespread panic selling.
The dot-com bubble hugely impacted the UK economy as tech startups failed, leading to unemployment. Also, there was a decreased demand for goods and services, which led to inflationary pressure.
2008
The 2008 financial crisis began with the housing market bubble, created by an overwhelming load of mortgage-back securities bundled with high-risk loans. This reckless lending by banks led many financial institutions to fail and require a government bailout.
The crisis led to the deepest UK recession since World War II, with rises in debt and unemployment. The inflation rate dropped from 3.52% to 1.96% as Brits had no confidence in the market.
Current Trends of Inflation in the UK
In October 2022, Britain’s inflation rate soared to the highest level since the early 1980s, reaching 11.1%. This was mainly due to the Russian invasion of Ukraine, which significantly put pressure on energy demands. Because energy costs trickle down into so many other parts of the economy, prices prices rose across the board on food, household items, clothing, and more.
Also to blame is the COVID-19 pandemic, which disrupted crucial supply chains and triggered mass money printing by central banks. In their efforts to provide furlough support to workers and stimulate growth as businesses opened back up, money supply increased dramatically. Currently, the Bank of England is trying to reduce inflation to 2% by implementing policies and changing interest rates.
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