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What is inflation and what does it mean for you?

inflation People buy food at a market in Budapest, Hungary, December 3, 2022. REUTERS/Marton Monus
Lower food prices has kept inflation steady at 4%. (REUTERS / Reuters)

Inflation has dominated the news for the past years, but while it has played a key role in all our financial lives, a lot of people aren’t entirely sure what it is, why it soared so high, or what it means for them.

At its heart, inflation is a way of expressing how much less of a bang you’re getting for your buck over time.

The Office for National Statistics (ONS) tracks the price of a huge range of goods — from yoga pants to fishing rods. It looks back to how prices have changed over the previous year and expresses this as a percentage.

So 4% inflation really means prices have risen 4% in a year — or something that cost £100 this time last year costs £104 today.

After a decade of bumping along the bottom, it started ratcheting up in 2021 — peaking at an eye-watering 11.1% in October 2022, and spending more than half a year at more than 10%.

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Read more: UK inflation holds steady at 4%

It has since dropped back to 4%, but is still streets ahead of the Bank of England’s (BoE) target of 2%.

There are a host of reasons for this surge in price rises.

It started with how the authorities tried to manage the economy during COVID lockdowns. When the bottom falls out of demand, the BoE gets worried about prices falling, so it cuts interest rates as low as possible. This encourages people to borrow and spend, boosting demand and stimulating inflation. This is what it did during the COVID pandemic.

At the same time, it did what’s known as quantitative easing — which effectively means it printed money to pump into the economy, to get demand moving. It also paid people to stay home, which meant a lot of pent-up demand from lockdown savings.

All this extra demand started to feed into the economy when we emerged from lockdowns in 2021, so prices started rising. The BoE tolerated this until the end of 2022, keen not to raise interest rates too quickly in case it tipped the economy into serious trouble. However, at the end of 2021, it started raising rates — and only stopped doing so in August last year.

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Unfortunately for the Bank, the start of the rate rise cycle came just ahead of Russia’s invasion of Ukraine, in early 2022. This was not only a humanitarian crisis, it also made it far harder to tackle inflation. It caused huge supply problems, most notably for oil and gas, which sent prices through the roof.

A higher oil price not only makes it more expensive to fill our cars and heat our homes, but it raises the price of everything that needs to be grown, manufactured, transported or sold — so inflation rose still further.

inflation
Being in the dark about inflation could have a nasty impact on our finances — particularly our savings. Photo: Getty (Peter Dazeley via Getty Images)

What does this mean for you?

This hasn’t just been a catastrophe for our budgets. If you have savings, it also eats into the spending power of money you’ve put aside. Let’s take the example of £1,000 in a savings account paying 3%. When you add the interest, by the end of the year you’d have £1,030 in your account. It looks like you’re richer, but when you take the impact of rising prices into account, it eats into that return. So if inflation was at 4%, the buying power of £1,030 would actually fall to £990, so you’d lose money after inflation.

This isn’t widely understood. Financial service company Hargreaves Lansdown asked people to guess roughly what would happen to their spending power and only two in five got the answer right. One in 20 said nothing would happen to their spending power, and 15% thought they would have more at the end of the year. One in three said they couldn’t even begin to work it out.

Unsurprisingly, those who got to grips with inflation were more likely to be making the most of their savings — because it’s only when you realise the damage inflation can do that you realise just why it’s so important to get the best possible rate.

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Some of this is because those who don’t feel equipped to answer a question on inflation are less likely to have the financial skills to make the best possible decisions.

But it also owes a lot to a lack of confidence, which may have convinced them it’s hopeless even to try to get to grips with money.

The frustration is that this group is the most in need of financial education, but they’re the least likely to feel engaged enough to ask for help.

How to get educated

It’s important for anyone in this position to know there is support available.

If you feel like you're in the dark, the key is to start small — whether it’s watching videos, using MoneyHelper to read up on some of the basics, or talking to friends and family who have a head start.

If you can take the time to close some of the gaps in your understanding you don’t need to spend your time feeling bad about what you don’t know — you can feel good about what you’ve learned instead.

Watch: How does inflation affect interest rates?

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