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What is inflation?

We hear about it all the time. But what actually is it and how much does it affect us? Here, we explore the basics in a bit more detail.

Inflation definition

Inflation is the rate that prices for clothes, food, travel and the like go up over time – e.g. over a year or month. The rate can fluctuate a lot, but when it’s high, how much you can buy with your money (its ‘purchasing power’) actually decreases.

Plus, if your wages don’t rise in line with inflation, you can be left falling short in terms of buying power or even living standards.

Why do we have inflation?

We know what you’re thinking, ‘any rise in price is a bad thing.’ But a bit of inflation helps businesses set their prices accurately and keep them stable, which actually encourages spending. Inflation also enables the Bank of England to set interest rates.

If prices rise too much, people struggle to plan for the amount they’re spending and will have less left over for any extras.

Having said that, falling prices aren’t as good as they may sound either.

Everyone loves a bargain…

Everyone enjoys a bargain, but it doesn’t actually encourage spending if prices consistently drop. It leaves people thinking they will get a better deal later so they might not spend anything in the here and now.

It sounds savvy, but it can actually cause a spiral of falling prices – known as deflation.

What is deflation?

Deflation is what happens when the rate of inflation drops below 0%[1].

It can be terrible for businesses since companies (understandably) can’t sell their products for a reasonable price, so may need to lay off employees, for example, to try and offset the damage, or reduce salaries if employees do keep their jobs.

It can become a vicious circle of dropping prices to sell stock and cutting staff to stay afloat. If this is happening across a lot in different sectors, the economy can go into reverse – a recession.

Inflation rate

Inflation is specified as a percentage. At any given time, the rate will be different everywhere. For example, in April 2021, the UK inflation rate was 1.5% [2], but in the US it was 4.2%[3] – this is how much higher prices are on average compared to the same time the previous year.

In the UK, the Bank of England has a target of 2% per year[4] for inflation. The Bank even has to explain to the Government of the day if it fails to meet this target by more than 1% (so below 1% or above 3%).

How to measure inflation

Q: so how does the Bank of England decide on the inflation rate?

A: using a shopping basket of goods created by the Office for National Statistics (ONS).

That’s right. The inflation basket is a huge theoretical basket of goods filled with thousands of prices for hundreds of products and services. What goes in the basket depends on the most popular items.

The baskets in 2020 and 2021 were quite different to baskets from previous years because of, you guessed it, Covid-19.

The ONS showed that the 2021 shopping basket featured hand sanitiser, home workout weights such as dumbbells, and women’s sweatshirts[5].

In 2020, items or services that just couldn’t be purchased like pints of beer, Euro tunnel tickets, haircuts and cruises[6] were simply removed from the basket.

This enormous shopping basket works out the CPI, CPIH, and RPI – different measurements of inflation. Let’s break them down.

Measurements of inflation


The Consumer Prices Index is the one you’re most likely to hear about. This takes into account all goods and services. Items are weighted based on how popular they are.

For example:

Bread = very popular, so can have more whack when determining the index.

Women’s jeans = less so.


The Retail Prices Index tends to come out the highest out of all three measurements. It takes some housing costs into account, but it doesn’t account for people making changes when prices go up. It’s also massively influenced by house prices and interest rates[7].

The problem with RPI

A lot of experts don’t think RPI is a good measurement anymore – it’s no longer used to determine a rise in the State pension or the Bank of England’s inflation target (both linked to CPI). But it still impacts how much we pay for some items, including train fares, student loans and phone bills – all considered high enough as it is…

A lot of economists think CPIH is now the way to go for determining prices.


This is the Consumer Prices Index Including Owner Occupiers' Housing Costs. Thank goodness they only added on one letter…

CPIH is favourable with the ONS as it builds on CPI by including housing costs, such as gas, water and electricity. It’s a bit of an all-rounder.

Hyperinflation: what happens when inflation gets out of hand?

Hyperinflation is when the prices rise by more than 50% in one month; bear in mind the 2% goal for the UK – this should give you an idea of scale.

Though rare, hyperinflation is devastating. One of the most famous examples is Germany after WW1 – the country couldn’t afford to pay the war reparations they were charged, and the Wall Street Crash on top of that meant the US began recalling all of its loans. The Weimar Republic printed more money to cope with the debt and to pay more to Germany’s many unhappy, striking workers, but more printed money meant rising prices which led to hyperinflation.

Well-known pictures show people wheeling huge amounts of money around to pay for some milk and bread or children playing with wads of cash because the mark was essentially worthless.

More recent examples come from Zimbabwe in the late 2000s, which resulted in people refusing to use the currency, and Venezuela (where hyperinflation was at 10 million percent (!) in 2019[8]) which is ongoing.

Did you know…?

The reason printing more money doesn’t work is because you’re not actually adding to economic growth – the amount you can buy has remained the same, there’s just more cash swimming about. More money and the same amount of goods just means businesses and services up their prices.

This means the money is worth less, and sometimes becomes worthless when it gets out of control, because you’re buying the same amount of goods or services for more money.

How much does inflation affect us?

Even though it’s irritating to see your bus ticket go up by 20p, it doesn’t ‘break the bank’ as it were. But over time, it can seriously mount up.

For example: £10 in 1920 is equal to £457.08 in 2020, and £10 in 1820 is £988.38[9] in today’s world! That’s inflation.

As with most things, individual circumstances play a large part in how you’re affected too.

If you’re saving money for retirement and inflation is consistently high, you might feel quite hard done by because it reduces how far your money can go in the future.

That’s why pensions are put into the stock market, so they have a chance of actually beating inflation and aren’t at the mercy of low interest rates. You can see a comparison of cash vs investing in our Investing 101 series.

If you’re the Government, you might feel a bit better about the inflation rate picking up a tad – it can boost the economy if it’s a small rise, and a large rise effectively reduces government debt. 

Interest rate

Since inflation helps to set the UK’s interest rate, high or low inflation can affect you depending on if you’re a saver in the bank or a borrower from the bank.

If the interest rate is high (usually higher inflation = higher interest rates), you’re in luck if you’re a cash saver as it boosts what the bank pays you to keep your money in their savings account. If you’re a borrower, you pay more to borrow money from them.

If interest is low, the opposite tends to be true. Cash savers lose buying power and interest rates keep their money stagnant in cash accounts and borrowers will pay less back to buy a house, for example.

Get in touch

If you want to speak to us about anything you’ve read in this article, give us a call on 020 7189 2400 or email

Alternatively, if this article has given you the bug to put some of your hard-earned money to work instead of sitting in a cash account, you could open an award-winning (psst – all our awards can be found hereStocks & Shares ISA or Best SIPP*  with us.

[1] Bank of England, 2021

[2] BBC News, May 2021.

[3] Consumer-price inflation in America jumps up to 4.2%, The Economist, May 2021.

[4] Bank of England, 2021.

[5] ONS, April 2021.

[6] This Is Money, 2020.

[7] The Times, May 2021.

[8] CNBC, 2019.

[9] Inflation calculator, Bank of England, 2021.

*SIPPs are not suitable for everyone. If you don’t want to invest across different asset classes or don’t think you will make use of the investment choices that SIPPs give you, then a SIPP might not be right for you.


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