What is inflation and how is it calculated? Experts predict rate to drop amid food shortages

·4 min read
The rate of inflation has hit a 41-year high  (PA Wire)
The rate of inflation has hit a 41-year high (PA Wire)

The UK will have one of the highest inflation rates in the G20 this year, according to the latest Organisation for Economic Co-operation and Development (OECD) forecast.

The inflation rate was 8.7 per cent as of April 2023, as measured by the Consumer Prices Index (CPI), decreasing from 10.1 per cent in March 2023.

This is compared with a rate of seven per cent in Europe and 4.9 per cent in the US. In the G20 table of inflation, the UK is only ahead of Turkey and Argentina.

However, the OECD predicts that the UK will avoid a recession. This forecast comes after Chancellor Jeremy Hunt said he would be comfortable with the Bank of England hiking interest rates, even if it forced Britain into a recession, in order to stabilise the economy.

But what is inflation and what does it mean for wages and mortgages?

What is inflation?

Inflation is a measure of the rate of rising prices of goods and services in an economy. It can occur when prices rise due to increases in production costs, such as raw materials and wages.

For example, if a bottle of milk costs £1 and that rises by 5p compared with a year earlier, then milk inflation is five per cent.

A surge in demand for products and services can cause inflation, as consumers are willing to pay more for the product.

What causes inflation?

There are various factors that can drive prices or inflation in an economy. Typically, inflation results from an increase in production costs or demand for products and services.

In the short term, high inflation can also be the result of people having a lot of surplus cash, or accessing a lot of credit and wanting to spend.

Despite consumers receiving little to no benefit from inflation, investors can profit if they hold assets in markets affected by it. For example, those who’re invested in energy companies might see a rise in their stock prices if energy prices are rising.

How is inflation calculated?

Inflation is calculated by measuring changes in the cost of living, and the official method used is the CPI. It is worked out by measuring the price of a “basket of goods” and services we use every day. This basket includes everything from the price of eggs to how much an e-book costs.

It is determined by the annual Family Expenditure Survey, a voluntary survey of about 6,000 people. The survey conducted by the ONS helps to determine the percentage of people’s incomes that are spent on different things. The results differ every year to reflect people’s shopping habits.

Once the survey results are in, the Government checks the prices of the 1,000 most common goods in the UK every month. The percentage changes in the price of individual goods and services are noted.

Percentage increases in price are then multiplied by the weighting the particular product category has been given, which shows how much it is affecting consumer budgets.

How does inflation work?

Inflation occurs when prices rise across the economy, decreasing the purchasing power of money. It refers to the broad increase in prices across a sector or industry, and ultimately a country’s entire economy.

Inflation can become a destructive force in an economy if it is allowed to get out of hand and rise dramatically.

Unchecked inflation can topple a country’s economy, as it did in 2018, when Venezuela’s inflation rate hit more than 1,000,000 per cent a month. This caused the economy to collapse and forced countless citizens to flee the country.

What does inflation mean for mortgages?

Rising inflation will have an impact on homeowners, but how much depends on the terms of their mortgage.

The Bank of England may increase interest rates to try to slow inflation when it rises.

As a result, when interest rates rise, mortgages can become more expensive, although this will depend on their type.

People who have tracker mortgages, which track a base rate (usually the Bank of England’s), will see their interest rates rise a month after the Bank of England increases the base rate.

Meanwhile, people on fixed-rate mortgages won’t be affected immediately. These mortgages fix the interest rate a homeowner will pay for a certain length of time — usually two years or five years.

Once a tracker or fixed mortgage comes to an end, lenders can put borrowers on a standard variable rate (SVR) mortgage. This means mortgage payments could change each month, depending on the rate.

What does inflation mean for wages?

When inflation rises — and when wages don’t keep up — it affects the real value of pay. This means that wages don’t stretch as far as they used to.

The ONS said regular pay, excluding bonuses and considering inflation, nosedived by 4.1 per cent in the three months to June compared with a year earlier.

“The real value of pay continues to fall,” ONS director of economic statistics Darren Morgan said in January. “Excluding bonuses, it is still dropping faster than at any time since comparable records began in 2001.”