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News - 28 June 2012

What is Inflation?

And how will it affect me? These are questions we get asked on a quite regular basis, so, we asked Stuart and TK if they could produce a workable and easy to understand definition.

Stuart: “Inflation is the rate of change of prices for goods and services.

The two main measures of inflation most frequently used are the Consumer Prices Index (CPI) and the Retail Prices Index (RPI).  Each looks at the prices of hundreds of things we commonly spend money on, including bread, cinema tickets and pints of beer - and tracks how these prices have changed over time.

The main differences between the two indexes are that RPI includes housing costs such as mortgage interest payments and council tax, whereas CPI does not.

The inflation rates are expressed as percentages. If CPI is 3%, this means that on average, the price of products and services we buy is 3% higher than a year earlier. Or, in other words, we would need to spend 3% more to buy the same things we bought 12 months ago. So it reflects an erosion in every day purchasing power.”

Why is inflation important?

TK: “The CPI and RPI rates are used in many ways by the government and businesses, and play an important role in setting economic policy.

The Bank of England uses it to set interest rates. If the Bank's Monetary Policy Committee thinks inflation will be above 2% in the next two years or so, it may increase interest rates to try to subdue it.  However, if it thinks inflation is likely to be below 2%, it may cut interest rates.

It also has a direct impact on some people's incomes. Anything that is described as index-linked rises in line with inflation.  That includes state benefits, pensions and even train tickets. It is also used to set annual pay rises. However, due to the effects of the recession, many pay settlements have fallen behind price rises.

That's why inflation is crucial. From determining bank lending rates, mortgages, business loans and is a major problem when trying to plan for the future whether that is the household budget or a Business Plan.

How is inflation calculated?

Stuart: “On a monthly basis the Office for National Statistics (ONS) collects from all over the country, thousands of prices of goods from a wide range of retailers (on and off line). They are monitored and checked against the same goods, from the same outlets (ensuring Like for like comparisons) and they go towards calculating the Average Household Spend which in turn give us the rate of inflation.”

Are the effects of inflation always negative?

TK: “Inflationary effects on the economy can be both positive and negative.

Negative effects include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation which may discourage investment and savings, and if inflation is rapid enough, shortages of goods as consumers start to panic buy and hoard goods for the future (the recent petrol crises for example).
It can also have a positive effect as central banks adjust nominal interest rates to encourage investment and attempt to mitigate recessions.”

If you have any questions you want to ask our financial gurus, or, if you need advice on any tax or business matter, contact Tonmoy Kumar, Stuart Coleman or Lavinia Newman to discuss how ABDS can help bring their experience to these matters.

ABDS Chartered Certified Accountants of Southampton.
Tel: 023 8083 6900  E-mail: abds@netaccountants.net

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