What is inflation and how is it calculated? Food shortages causes unexpected rise

The rate of inflation has hit a 41-year high  (PA Wire)
The rate of inflation has hit a 41-year high (PA Wire)

Inflation rose to 10.4 per cent in February up from 10.1 per cent in January in a suprise reversal of a recent downward trend.

The upward push is a result of food and non-alcoholic drink prices reaching their highest rate in more than 45 years. It may also force the Bank of England to raise interest rates higher to slow price growth as a result.

ONS chief economist Grant Fitzner said: “Inflation ticked up in February, mainly driven by rising alcohol prices in pubs and restaurants following discounting in January.

“Food and non-alcoholic drink prices rose to their highest rate in over 45 years with particular increases for some salad and vegetable items as high energy costs and bad weather across parts of Europe led to shortages and rationing.

“These were partially offset by falls in the cost of motor fuel, where the annual inflation rate has eased for seven consecutive months.”

It is the first rise in inflation since October 2022, and leaves price rises a long way from the Bank of England’s goal of 2 per cent.

In addition, the rise makes Chancellor Jeremy Hunt’s announcement that inflation was expected to fall to 2.9 per cent by the end of the year appear less likely.

But what is inflation, how does it work, and how is it calculated? Here’s everything you need to know.

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.

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