What is driving inflation, and is it here to stay?


two masked workers clean an empty café during the pandemic

The ever-increasing cost of living has dominated headlines over recent months. The inflation rate is at its highest point for more than three decades, meaning that the cost of living is rising faster now than it has been at any time in the last 30 years.

There are several factors that have contributed towards the unprecedented rise in the inflation rate, with Covid-19 seemingly at the centre of it all. But what is inflation, what has caused the cost of living to rise, and is inflation here to stay? Read on for the answers to all these questions and more.

What is inflation?

In simple terms, the inflation rate is the average rate at which prices rise. According to the Office for National Statistics, the inflation rate for the 12 months to January 2022 was 5.5%. This means that, on average, the price for goods and services you buy is 5.5% more than it was 12 months ago.

Inflation can significantly change the pricing of everyday items over many years. According to the Bank of England’s inflation calculator, goods and services worth £100 in 1981 would cost £375.53 now, with an average inflation rate of 3.5% a year during that period.

Inflation is calculated using a “basket of goods”, where the price changes of hundreds of everyday items are considered. Items we spend more on as a society, like petrol or chocolate, for example, are given more weight.

What has happened to inflation recently?

The cost of living typically always rises, and inflation is a normal part of life. Indeed, the Bank of England (BoE) targets an inflation rate of 2% a year.

However, the last time inflation was higher than 5.5% was in March 1992, so the current rise in the cost of living is unusual.

The high inflation we are experiencing today is caused by several factors, potentially the largest of which being the long-lasting effects of the Covid-19 pandemic.

Financial analysts predicted that there would be a spike in the inflation rate as world economies began the difficult process of reopening, but the spike has lasted longer than many anticipated.

Companies across a range of sectors have struggled to keep up with the increased demand brought about by the end of the pandemic. Many have been unable to source the raw materials they need, or the cost of these has risen due to shortages. This has pushed up the price of goods and services.

Labour shortages caused by Brexit and global supply chain issues have also contributed to the supply and demand problem, making it harder to produce, send, and receive goods and materials.

When demand is high and supplies are low, prices tend to rise.

Is inflation here to stay?

To try and curb the inflation rate, the BoE has twice raised the base rate of interest in recent months.

If borrowing money is more expensive, then people will have less money to spend. Plus, if the interest rate on savings accounts is good, then people will be more inclined to save their money rather than spend it. Both these factors should reduce demand for goods, and dampen price rises.

Many experts believe that the current period of higher inflation is transitory, and that rises in the cost of living will return to more normal levels later in 2022.

One reason is that so-called “supply-side inflation” – demand outstripping supply, thereby creating scarcity – is often short-term in nature. When businesses realise there is robust demand, they increase production.

Azad Zangana, senior European economist at Schroders, told FTAdviser that he believes the present very high level of inflation in the UK will peak in April, when energy prices will rise sharply, and then begin to fall back in autumn.

However, one of the problems faced by the BoE is that raising interest rates is designed to control “demand-side inflation”.

The idea is that, if the interest rate available on savings rises, it may encourage people to defer spending. Similarly, if the rate of interest on borrowing rises, this means people will have to spend a greater amount of their income on debt repayments, reducing their level of spending in the economy.

The BoE is essentially hoping that, by signalling to the world that they are determined to address higher inflation, and if people believe inflation will soon fall, then their economic behaviours will adjust – resulting in a decrease in the inflation rate.

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If you’re concerned about inflation and the effect on your wealth, please get in touch. Email info@investmentsense.co.uk or call 0115 933 8433.