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What is inflation and how is it measured in the UK?

Inflation is a measure of how much the prices of goods and services have risen over a particular period of time. This could be a snapshot of the big picture, such as a country’s overall increase of prices, or it can focus on certain goods or services such as food, energy or nursery fees. For example, if a loaf of bread costs £1.25 and then a year later £1.50, the rate of inflation for bread would be 20% for that year.

There are different measures, but the Office for National Statistics uses the Consumer Prices Index or CPI to track the overall figure talked about in relation to cost of living. The CPI records the monthly percentage change of each item in a typical ‘shopping basket’ of around 730 goods and services in comparison to the same time in the previous year. These goods are updated to reflect shopping trends.

The Bank of England (BoE), the UK’s central bank, has the job of ensuring prices don’t rise too quickly, so its primary objective, as set out in its mandate by the UK government, is to maintain price stability.

It has been given a yearly target inflation rate of 2% (an average of the prices in the shopping basket). This means that the Bank of England aims to keep inflation around this point, which is typically set at 2% for the CPI. The figure of 2% is calculated by taking an average of the prices in the shopping basket. At the present time inflation is 6.7% in the year to September 2023, the same rate as in August, but slightly down from July. 

How does the BoE tackle inflation?

The BoE’s Monetary Policy Committee (MPC) uses interest rates as a tool to help control inflation by adjusting its official interest rate, known as the Bank Rate or base rate. This influences commercial banks, which will usually adjust their own interest rates on saving and borrowing to align with this rate. 

When the MPC believes that inflation is rising above the target, it may raise the Bank Rate. Higher interest rates can make borrowing more expensive, reduce consumer spending and business investment, and slow down economic activity. This, in turn, can help reduce inflationary pressures.

Take a look at the infographic below to see how inflation has risen and its outlook heading towards 2025.

UK inflation rate and forecast, Consumer Prices Index, 2015 to 2025

In addition to interest rate policy, the Bank of England may employ quantitative easing or QE. This involves buying financial assets, typically government bonds, from the market. This injects money into the economy and encourages lending and investment, all of which can help combat deflation or stimulate economic activity.

Since November 2021, the Bank has increased interest rates on 14 successive occasions. In September, however, the bank held rates at 5.25%. This has coincided with the inflation rate slowing down, although this doesn’t mean prices will fall – only that they will rise less quickly.

Businesses may face their own challenges such as making decisions about whether to hike up wages as staff ask to be paid more to stay in line with high inflation; buying new equipment; or a wave of supply chain pressures. Take a look at your cash-flow forecasting to find out why growing a cash reserve could help meet these challenges.

Inflation and savings: how does it impact your savings plan?

It could be worth reconsidering your savings strategies because inflation can gradually erode the purchasing power of savings over time. This can occur in two ways. 

  1. Reduced purchasing power: Each pound held in savings becomes less valuable because it can buy fewer goods and services. This means that the same amount, for example £500, will not stretch as far in the future as it does today.
  2. Loss of real value: If savings don’t grow at the same rate or higher than the UK inflation rate, the real (inflation-adjusted) value of savings decreases. For example, if you’re earning 2% interest on your savings but UK inflation is running at 3%, you are effectively losing 1% of purchasing power annually.

Are your savings growing at the same rate as inflation?

Keeping money in a savings account that earns interest could offset some of the effects of high inflation, although it’s unlikely that savings in a deposit account will grow fast enough to completely balance out the inflation loss.

Can you reinvest to help get a better return to protect your cash?

Your tolerance to risk will lead your decision on how to reinvest your money. Those with a higher tolerance might consider investing in funds, stocks, bonds, or other assets over the medium to long term.

This approach offers potential opportunities to outpace inflation and increase cash reserves. It’s important to note, however, that there are no certainties in investing. The value of these investments could go down as well as up and you may not get back the full amount you invest. Seeking guidance from an independent financial adviser could help to ensure that any investment choices align with a business’s unique financial requirements.

For those looking to grow savings with less risk, fixed-rate savings accounts could be another option. Your money will usually be locked away for a fixed time so you may not have instant access but they come with higher interest rates compared to instant access accounts, so this could benefit your savings plan.

They can be a less risky option than stock market investments, allowing users to predict the amount they’ll receive at the end of the fixed term, therefore simplifying the financial planning process and the overall economic outlook.

For more insight check out our latest finance articles.

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This material is published by NatWest Group plc (“NatWest Group”), for information purposes only and should not be regarded as providing any specific advice. Recipients should make their own independent evaluation of this information and no action should be taken, solely relying on it. This material should not be reproduced or disclosed without our consent. It is not intended for distribution in any jurisdiction in which this would be prohibited. Whilst this information is believed to be reliable, it has not been independently verified by NatWest Group and NatWest Group makes no representation or warranty (express or implied) of any kind, as regards the accuracy or completeness of this information, nor does it accept any responsibility or liability for any loss or damage arising in any way from any use made of or reliance placed on, this information. Unless otherwise stated, any views, forecasts, or estimates are solely those of the NatWest Group Economics Department, as of this date and are subject to change without notice.

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