What Is Inflation?
In economic terms the word inflation is used to describe a general rise in prices across the whole economy over a sustained period.
There are several ways to measure inflation. In the UK the two main measurements are the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). Although similar in approach, they differ slightly in coverage and method of calculation.
Both the RPI and the CPI measure price changes in a representative 'basket' of goods and services to produce a monthly overall index of prices.
This is done by collecting sample prices of hundreds of goods and services bought by UK households and measuring the average price changes in those items from month to month. Currently (2011) approximately 180,000 prices, covering 650 goods and services, are collected each month from around 150 areas in the UK.
Items in the 'basket' are weighted to reflect spending patterns; those on which consumers spend the most money have a higher weighting. The goods and services included in the 'basket' are reviewed each year, with changes made if necessary to ensure the 'basket' remains representative of current spending patterns.
However, some goods and services included in the RPI measurement are not included in the CPI measurement, for example mortgage interest payments, Council Tax, TV licence and trades union subscriptions. And the CPI includes charges and fees which are not included in the RPI such as stockbroker fees, foreign student tuition fees and unit trust fees.
Also, because the CPI and the RPI are constructed using different formulae, (the RPI uses an arithmetic mean and the CPI a geometric mean), the CPI inflation figure will be lower than the RPI figure.
The RPI was first used at the time of the First World War and, following a number of changes and developments, went on to become the main measure of domestic inflation in the UK. The CPI was introduced in 1996 and is an internationally comparable measure of inflation. Up until December 2003 it was published in the UK as the HICP (harmonised index of consumer prices).
An inflation target is set by the Government each year and announced by the Chancellor in the annual Budget statement. From June 1997 to December 2003 the inflation target was 2.5% based on the RPIX measure of inflation; this is the same as RPI except it does not include mortgage interest payments. In December 2003 the target was changed to 2% based on the CPI measure of inflation.
One of the Bank of England's main objectives is to keep prices stable and inflation low, thereby ensuring a stable economy. If inflation moves away from the target (still currently 2%) by more than one percentage point on either side (i.e. more than 3% or less than 1%) the Governor of the Bank of England must write to the Chancellor explaining in his letter:
why inflation moved away from the target;
the period within which the Monetary Policy Committee expects inflation to return to target;
the policy action being taken to deal with it;
how this approach meets the Government's policy objectives.
If after three months inflation remains above or below the target by more than one percentage point, the Governor must write another explanatory letter to the Chancellor. This process continues until inflation is brought back under control.
The classic description of inflation is "too much money chasing too few goods"; in other words the demand for goods and services exceeds the economy's ability to supply those goods and services – and when products are scarce, prices rise.
There is also the cost element. Companies may increase production in order to meet the increase in demand, but only by incurring increased costs which they will then need to recoup – and so when costs rise, prices rise.
Conversely, if supply outstrips demand this can lead to deflation – a general fall in the prices of goods and services – which can be just as problematical as inflation.
In order to control inflation therefore, it is essential to maintain a steady balance between the growth in demand and the growth in supply.
History shows that a recurring cause of an imbalance between demand and supply leading to high inflation is war. This is because so much money is spent in wartime on producing arms and too little spent on other goods and services that shortages are created – and again when products are scarce, prices rise.
According to the Bank of England, the highest inflation ever recorded in Britain was at the time of the wars with France – the French Revolutionary Wars which began in 1793 and led on to the Napoleonic Wars. A similar situation was seen at the time of the First and Second World Wars.
Following the French wars, inflation was brought under control in Britain by adopting the gold standard which linked the value of paper money to the price of gold. Bank of England notes could in theory be redeemed for gold in the Bank's vaults and the amount of money in circulation could not exceed the reserves of gold. This ensured the value of money was stabilised, which in turn led to stable prices and several years of stable inflation.
However, as had happened with the French wars, the link between gold and the pound was broken during the First World War with more and more bank notes being printed which could not be redeemed against gold. Years of deflation followed between 1921 and 1933 and despite the link being restored in 1925, this failed to halt the constant fall in prices. Britain finally left the gold standard in 1931.
Inflation was stabilised again after Britain joined the Bretton Woods system in 1944, which linked the currencies of participating countries to the US dollar which was in turn linked to gold reserves. However, the system collapsed in 1971 and Britain once again faced problems of rising prices and high inflation.
In 1992 the then chancellor, Norman Lamont, announced that the Government had decided to introduce a specific inflation target as part of a new monetary policy framework. Shortly after Labour returned to power in 1997 the new chancellor, Gordon Brown, made the Bank of England independent of political control. The Monetary Policy Committee became responsible for setting interest rates at a level which would ensure the Government's inflation target was met.
A period of stable inflation then followed, until the global financial crisis contributed to fluctuating CPI inflation rates between 2008 and 2011 reaching a record high of 5.2% in September 2008. CPI inflation remained at over 4% in 2011 as the Government struggled to reduce the huge deficit it inherited on coming to power in May 2010.
However, inflation began to fall towards the end of 2011 and by May 2012 was once again within the target.
The announcement by the Government that from April 2011 the CPI measure of inflation, rather than the RPI, would be used for the indexation of benefits, tax credits and public service pensions attracted considerable criticism.
Organisations representing thousands of public sector workers including the Police Federation, the GMB, Prospect, the FDA and the National Association of Retired Police Officers, have called for a judicial review into the planned changes which affect the way public sector pensions are uprated.
John Amos, deputy general secretary of the Civil Service Pensioners' Alliance (CSPA) said "On the basis of OBR forecasts, the change will rob existing pensioners of 8.5% of their expected pensions by 2017 and, according to Lord Hutton, up to 25% over a lifetime."
The Government also confirmed that it was reviewing how the CPI can be used for the indexation of taxes and duties.
In 1923, Germany experienced one of the most famous episodes of hyperinflation.
In December 1923 wholesale prices were over 85,000,000,000% higher than a year earlier.
The highest denomination bank notes had a face value of over 1000,000,000,000 marks.
By October more than 99% of bank notes had been in circulation for less than 30 days.
In 1946, Hungary experienced the highest inflation ever recorded.
In the peak month of July 1946 prices were doubling in little more than 12 hours.
The largest denomination bank note in circulation was worth 100,000,000,000,000,000,000 pengo.
Source: Bank of England
CPI annual inflation stands at 2.8 per cent in May 2012, down from 3.0 per cent in April. The largest downward pressures to the change in CPI annual inflation came from motor fuels and food & non-alcoholic beverages. The largest upward pressures to the change in CPI annual inflation came from air and sea transport, where the timing of Easter had a significant impact on the April to May movement. The CPI stands at 122.8 in May 2012 based on 2005 = 100
RPI annual inflation stands at 3.1 per cent in May 2012, down from 3.5 per cent in April. The largest downward pressures to this change came from petrol & oil and food. Partially offsetting these was an upward pressure from other travel costs which includes air transport. The RPI stands at 242.4 in May 2012 based on January 1987 = 100
Source: ONS – June 2012
"This morning we had the news that inflation is down and within 1% of the Bank of England’s target – falling from 3.5% to 3%. It means that for the first time since I became Chancellor, I have not this morning received a letter from the Governor of the Bank of England explaining why inflation is off target. Indeed, it’s the first time since 2009 this has happened.
"This brings welcome relief to families on tight budgets – and the Bank of England expects inflation to continue to fall further over the next year or so."
Chancellor George Osborne – May 2012