What is inflation?

Inflation should be thought of from two different – equivalent – perspectives:

1. Inflation is the rate of increase in the general level of prices in the economy
2. Inflation is the rate at which the value of money is falling, when measured in terms of the goods and services you can buy

They’re equivalent because, whichever way you look at it, one pound today can buy less ‘stuff’ than it could last year (if inflation is positive). Inflation is reported as a %, on a month-to-month (MoM) and a year-to-year (YoY) basis. A ‘normal’ annual rate of inflation – and that targeted by many developed market central banks – is about 2%. This is considered to be a ‘moderate’ rate of inflation. Low or negative inflation is undesirable because it both reflects low or negative economic growth and deters future growth. High inflation is also undesirable because it reflects a loss of confidence in the value of money in the economy, and can mean falls in living standards if wage rises don’t keep up with price rises.

On that note, two important real-world reasons to understand inflation are:

1. So you can do a mental adjustment of interest rates, from nominal to real. For example, if your bank pays you 1% p.a. on your savings but inflation is 2%, then your real interest rate is -1%.
2. So that you can better assess your wage rises. For example, if your employer gives you a 1% raise, but inflation is 2%, you’ve had a real pay rise of -1% (i.e., a 1% pay cut).

In both cases, inflation is the difference between nominal and real numbers, something we discuss in more detail in this article. A third important use is in financial planning; neglecting the impact of inflation when measuring future values of things like your expected income, expenditures, investment returns, cost of debt, etc. can make a huge difference to your results.

More detail

Inflation is a deep and complex topic. Economists, policymakers, investors, and academics the world over are constantly thinking about how they can best understand it, measure it, manage it, use it as a tool, and make money from it. Historically, some of the most important economic events and changes in policy globally have been directly linked to the state of inflation.

Inflation has generally been positive in most countries for most of history. A positive inflation rate means prices are generally going up. ‘Generally’ here means on average, but not just a simple average. The prices measured by inflation are a basket of goods and services that are commonly purchased in a given economy. The basket doesn’t capture everything we buy, but it should be representative of the things an average person buys. Different measures of inflation – especially in different countries – may measure different baskets, have subtly different calculation formulae, and have different ‘rules’. In the UK, the main two measures are the Retail Price Index (RPI) and the Consumer Price Index (CPI). CPI is now the more commonly used measure and favoured by investors and economists, but RPI still has some important legacy uses, such as the indexation of pension payments.

An understanding of inflation is important for pretty much everything in finance, which is why it is one of our second-nature skills. Given the size of the topic, in this article we only explain the basics (in keeping with our aim to make our posts ‘bitesize’), but we’ll regularly post more detailed articles related to inflation in the advanced, topical and opinion sections.