The Inflation Effect.

Inflation measures the decrease of purchasing power of a given currency over a specified period of time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in previous periods.

Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.

Some economists describe the UK’s current cost of living situation as one of ‘stagflation’. Stagflation is usually characterised by slow economic growth and relatively high unemployment (although unemployment in the UK is currently at an historic low) or economic stagnation which is at the same time accompanied by rising prices. Stagflation can be alternatively defined as a period of inflation combined with a decline in a country’s gross domestic product (GDP). 

Inflation and the cost of living crisis

High and variable rates of inflation can impose major costs on an economy and impact people and families dramatically. Businesses, workers and consumers must all account for the effects for the rising prices in their buying, selling, and planning decisions. This introduces an additional source of uncertainty. Time and resources expended on researching, estimating, and adjusting economic behaviour are expected to increase the level of prices, rather than real economic fundamentals which inevitably represents a cost to the economy as a whole.

Along the way, this increases some prices first and others later. This sequential change in purchasing power means that the process of inflation not only increases general price levels over time, but it also distorts relative prices, wages, and rates of return. Economists explain that distortions of relative prices away from their economic equilibrium are generally not good for the economy, and some economists believe this process to be a major driver in cycles of recession.

Who calculates inflation?

Inflation in the U.K. is calculated by The Office for National Statistics (ONS), which notes the prices of hundreds of everyday items. These items are known as a basket of goods and they are constantly under review.
The ONS releases its measure of inflation each month, showing how much these prices have risen since the same date last year. This is known as the Consumer Prices Index (CPI). Another measure of inflation takes into consideration the same basket of goods but also includes household costs (such as council tax and mortgage interest payments) and this is known as the Retail Price Index (RPI).

Central banks and monetary policy

Historically, central banks (e.g. The Bank of England, The European Central Bank and The Federal Reserve) have raised interest rates as one mechanism of tackling inflation. However, over time, this method has proven to be less effective with the vast majority of borrowers now in fixed rate arrangements - these deals do have to be renegotiated at some point though to avoid typically being subject to a standard variable rate. The timing of interest rate changes is also an important balancing manoeuvre as the economy has to be able to absorb the change too.

Investment and hedging against inflation

Holding alternative asset classes to cash such as property, bonds or shares are all a potential hedge against inflation. Gold and other commodities are also sometimes considered to be a hedge, although none of these are guaranteed to be. The price of oil, for example, has soared in recent months and although this could have represented an investment opportunity, it also has a negative impact on the economy as a whole due to the knock-on effect to the cost of the supply chain.

The current inflation (cost of living crisis) is widely considered to be a global challenge with different governments attempting to deal with it in varying ways. Economists have long argued that a little inflation is actually healthy for an economy but too much for too long is where the damage occurs. We have been here before (e.g. 1970s energy crisis) and we have learnt that once the issues driving inflation start to settle, calmer conditions tend to follow.