What is Inflation?
the inflation rate
price indices
changes in the inflation rate
Inflation is a general rise in prices across the economy. This
is distinct from a rise in the price of a particular good or
service. Individual prices rise and fall all the time in a market
economy, reflecting consumer choices and preferences, and changing
costs.
inflation is a general rise in prices across the economy
If the price of one item - say a particular model of car -
increases because demand for it is high, we do not think of
this as inflation. Inflation occurs when most prices are rising
by some degree across the whole economy.
the inflation rate 
We often hear about the rate of inflation being 2.0% or 2.7%
or some other number. The inflation rate is a measure of the
average change in prices across the economy over a specified
period, most commonly 12 months - the annual rate of inflation.
We typically hear about the annual inflation rate for a particular
month. If, say, the annual rate of inflation in January this
year was 3%, then prices overall would be 3% higher than in
January last year. So a typical basket of goods and services
costing, say, £100 last January would cost £103
this January.
price indices
There are a number of different measures of inflation in use
today. The most familiar measure in the UK is the Retail Prices
Index (RPI). But monetary policy is now based on the Consumer
Prices Index (CPI). Both measure the prices of products and
services that consumers buy. A price index is made up of the
prices of hundreds of goods and services - from basic items
like bread to new products, such as PCs. Prices are sampled
up and down the country every month; in supermarkets, petrol
stations, travel agents, insurance companies and many other
places. All these prices are combined together to produce an
overall index of prices.
the inflation rate is a measure of the change in prices over
a specified period
The goods and services included in the index are chosen and
weighted on the basis of the spending patterns of UK households
- for example, if gas bills account for around 1% of consumers'
total spending, then gas prices will account for about 1% of
the index. The percentage weights are revised annually to reflect
changes in spending patterns. Sometimes new goods and services
are added and sometimes they are taken out. A few years ago,
men's cardigans were removed - not many men wear cardigans these
days!
Until December 2003, UK monetary policy was based on a measure
of inflation called RPIX. RPIX inflation is almost the same
as RPI inflation but it excludes one component - namely mortgage
interest payments. But on
10 December 2003 the Chancellor of the Exchequer announced that
in future monetary policy would be based on a new measure of
inflation - the Consumer Prices Index. This is explained
under the heading 'The
current inflation target' in 'Policy Framework'. More information
and data on the measures of inflation are provided in other
sections.
changes in the inflation rate
Any individual price change could cause the measured rate of
inflation to change, particularly if it is large or if the item
has a significant weight in the price index. But we are more
interested in the general increase in prices rather than individual
price changes. A large rise in the price of petrol, for example,
might affect the overall rate of inflation. But unless this
price carried on rising, the annual rate of inflation would
eventually fall back again - the example in the box below
explains this, if you want to know more.
Events affecting a range of prices can also result in a change
in the inflation rate. For example, a rise (or fall) in oil
prices might affect the price of other goods if producers pass
on the increase (or decrease). But, again, unless the oil price
continues to rise (or fall), this influence on the inflation
rate will eventually wear off after a time.
A change in price
If petrol prices had been 50p a litre for some time and then
they increased in, say, February 2008 to £1 a litre while
no other prices changed, the annual rate of consumer price inflation
would increase. If petrol prices remained unchanged after that,
the annual rate of inflation would then fall back in the following
February 2009. That is because the annual rate of inflation
in say February 2009 measures the change in prices between February
2008 and February 2009, during which time the price in our example
has stayed the same at £1 a litre - the rise in petrol
prices recorded in February 2008 drops out of the calculation.
So, although the price of petrol remains at the higher level,
annual inflation is not higher after a year or more.
Similarly, if the value of the pound falls against other currencies
- ie the exchange rate depreciates - the price in the shops
of some imported goods might rise. But only if the exchange
rate keeps falling will this influence on inflation continue.
Price changes like those described can have other indirect
effects on inflation. But individual price changes in themselves
do not have a lasting impact on the inflation rate.
The rate of inflation in a particular month will depend
on movements in all prices. But we need to distinguish between
individual price changes - which might change the measured rate
of inflation for a period - and the notion of inflation as an
ongoing, general increase in prices.
©2000-2009 Bank of England.
