What Is Inflation? — A Guide to CPI, Causes, and Effects

How Inflation Is Measured

Inflation is measured by tracking prices of a representative "basket" of goods and services over time. In the UK, two main measures are used:

• CPI (Consumer Prices Index): The Bank of England's target measure. Tracks prices of approximately 700 representative items. The government's 2% CPI target has been in place since 2003. Does not include housing costs (mortgage payments or council tax).
• CPIH: CPI plus owner-occupier housing costs (using a rental equivalence measure). ONS's preferred measure of inflation since 2016.
• RPI (Retail Prices Index): An older measure. Includes mortgage interest payments and council tax. Higher than CPI during periods of rising mortgage rates. Still used for student loan interest in England, rail fare increases, and some index-linked gilts.

The basket is reviewed annually — items are added when they become common purchases (e.g., streaming subscriptions, oat milk were added in recent years) and removed when they become uncommon.

Causes of Inflation

Effects of Inflation on Different Groups

Real vs. Nominal Values

A key concept in understanding inflation is the distinction between nominal and real values:

• Nominal value: The face value in current pounds — not adjusted for inflation. "My salary is £35,000" is a nominal figure.
• Real value: Adjusted for inflation — represents actual purchasing power. If your salary rose from £35,000 to £36,750 (5% increase) but inflation was 7%, your real wage fell by approximately 2%.

To convert nominal to real: Real value = Nominal value ÷ Price index (with a base year of 100). To compare values across time, use the inflation calculator — it adjusts any past amount to its equivalent in today's money (or vice versa) using historical CPI data.

How the Bank of England Controls Inflation

The Bank of England's Monetary Policy Committee (MPC) meets every 6 weeks to set the Bank Rate (base interest rate) with the mandate to keep CPI inflation at 2%.

The mechanism of monetary tightening (raising interest rates to reduce inflation):

1. Bank Rate rises (e.g., from 0.1% to 5.25% between 2021 and 2023)
2. Banks pass higher rates to mortgage borrowers and savers
3. Mortgage payments rise → less disposable income → less spending
4. Higher savings rates → households save more → less spending
5. Businesses face higher borrowing costs → less investment, fewer jobs
6. Reduced demand → businesses raise prices less → inflation falls

This transmission takes 18–24 months to work fully through the economy, which is why the MPC must act pre-emptively based on inflation forecasts rather than current data alone.

Hyperinflation: When Inflation Becomes Extreme

Hyperinflation is conventionally defined as inflation above 50% per month (equivalent to approximately 13,000% per year). It occurs when a government loses control of money supply, typically by printing money to fund spending (monetising the deficit).

Historical examples:

• Weimar Germany (1923): Prices doubled every 3–4 days at peak. A loaf of bread cost 200 billion marks. Workers collected wages in wheelbarrows and spent them immediately.
• Zimbabwe (2008–2009): Peak inflation estimated at 89.7 sextillion percent per month. 100 trillion Zimbabwe dollar notes were issued.
• Venezuela (2016–present): Cumulative inflation of millions of percent; government introduced new currency twice.

Hyperinflation destroys savings, makes economic planning impossible, and typically collapses the currency — requiring replacement with a foreign currency or a new, more credible domestic currency.

Protecting Against Inflation

Common inflation hedges:

• Index-linked savings (UK): Index-linked savings certificates (NS&I) — returns track RPI; guaranteed to preserve real value. Premium Bonds pay a tax-free prize rate that adjusts to market conditions.
• Equities (shares): Over long periods, equities have historically outpaced inflation, though with volatility. Companies can raise prices alongside inflation, protecting revenue in real terms.
• Property: Residential property values and rents have historically tracked or exceeded inflation over long periods. But also highly illiquid and concentrated.
• Index-linked gilts: UK government bonds with coupons and principal linked to RPI. Low-risk real-return asset for institutional investors.
• Commodities: Oil, gold, and agricultural commodities are often inflation drivers themselves — holding them can provide a hedge. Gold is a classic store of value in high-inflation periods, though returns vary widely.
• Inflation-linked debt: If you have fixed-rate debt, moderate inflation works in your favour — the real value of your debt falls over time.

Common Questions

Why does the Bank of England target 2% inflation and not 0%?

Zero inflation (or deflation — negative inflation) is considered more dangerous than moderate inflation. In deflation, consumers delay purchases expecting prices to fall further — reducing demand and slowing the economy. Deflation also increases the real burden of debt (you repay more in real terms than you borrowed). A 2% target provides a buffer against deflation, allows for minor measurement errors in the CPI, and provides room for monetary policy to respond (interest rates can be lowered from a positive level, but cannot easily go significantly below zero).

What is the Fisher effect?

The Fisher effect states that nominal interest rates adjust one-for-one with expected inflation to keep real interest rates stable. Real interest rate = Nominal interest rate − Inflation rate. If inflation is 5% and a savings account pays 3%, your real return is −2% (you are losing purchasing power). Lenders demand higher nominal rates when they expect higher inflation to preserve their real return. This is why Bank Rate rises when inflation rises — the Bank must ensure real interest rates are sufficiently positive to dampen demand.

How does inflation affect a mortgage?

For fixed-rate mortgages: inflation erodes the real value of your remaining mortgage debt. If you borrowed £200,000 and inflation runs at 5% for 5 years, the real value of your debt falls to about £157,000 in today's money — even though the nominal balance is unchanged. Your fixed monthly payment also becomes cheaper in real terms. Variable-rate mortgages track the Bank Rate — rising interest rates (used to fight inflation) directly increase monthly payments, which is why the 2022–2023 rate cycle caused significant mortgage payment increases.