Different types of inflation explained

How is inflation measured?

So, how does everyone know the amount by which prices have risen? In the UK, this is a job for the Office for National Statistics (ONS). The ONS is the largest independent producer of official statistics and is responsible for collecting and publishing information relating to the economy, population, and society.

Every month, the ONS collates around 180,000 prices of 700 items. This is referred to as the ‘shopping basket’ and is supposed to represent a typical family’s spending.

As you can imagine, this shopping basket changes over time.

After the First World War, it contained things like a man’s brace set, corned beef, candles, and coal. By the 1960s, rabbit was out, and chicken was in. Frozen chips had been added and TVs joined football admission as part of our leisure spending. The 1980s saw fizzy drinks added along with pet food and DIY materials, while this year (2023) saw the addition of e-bikes, security cameras and frozen berries.

But by comparing movements in the cost of this basket year after year, the ONS can calculate what is known as the Consumer Prices Index, or CPI. This is used as the measure of inflation.

What is the inflation target?

The ideal scenario is for inflation to be low and stable. When it’s running at a high level, it means that incomes can’t keep pace with the rising costs of living – hence the cost-of-living crisis in 2022 and 2023. This is why the UK Government sets the Bank of England the target of keeping inflation at 2%.

Traditionally, the Bank’s way of controlling inflation is through interest rates. This means the cost of borrowing goes up and that has the effect of stopping people spending so much.

It takes time for interest rate rises to have the necessary effect, however. 12-18 months according to Richard Woolnough, manager of the M&G Optimal Income fund.

And there is no guarantee that it will fall back to its long term average. “4% is the new 2%” according to Dr Niall O’Connor, manager of Brooks Macdonald Defensive Capital, who thinks inflation will remain above target for many months to come.

The impact of inflation

As we all experienced in 2022/2023, an inflationary environment generally means we still have the same amount of money to spend but it doesn’t go as far because everything is more expensive. This affects our purchasing power.

It means weekly trips to the supermarket will cost more for exactly the same items, while rising fuel prices sees drivers having to pay extra to fill up their tanks.

We examined how prices in the UK have changed over time by using the Bank of England’s inflation calculator. For example, something that cost £10 back in 1950 would now be £276.15!

You can even see the increases over the last five years. You would have needed to pay £12.17 in 2023 for an item that would have been sold for £10 in 2018.

Different types of inflation

Economists will declare there are different types of inflation. The most common forms you may hear about are demand-pull and cost-push.

Demand-pull is when there is more demand for goods than there is supply. This is often seen as a healthier type of inflation as it’s caused by higher employment and wages. It can also be caused by supply shortages however, as we saw after the global pandemic in 2020.

Cost-push inflation, meanwhile, occurs when the cost of making goods increases and companies have to raise their prices in order to cover the shortfall. However, this can obviously put a strain on the consumer.

There is also the concept of built-in inflation. This is when expectations of future inflation actually end up causing inflation itself.

The idea is that as prices rise, workers demand higher wages to help them cover the spiralling costs. In turn, this causes production costs to rise, which can lead to prices going up again and so on.

What is disinflation?

Disinflation is still a period of inflation, but prices are rising by smaller amounts than they were before. In other words, the rate of inflation is falling.

In some cases, disinflation can suggest unemployment is rising or economic growth is slowing. It can also come about when central banks raise interest rates.

What is deflation?

The opposite of inflation is deflation. This is when the percentage measure of inflation drops below zero, meaning goods and services become cheaper.

On the face of it, this sounds great, right? If everything is less expensive it should mean that you can afford to buy more items – including those that were previously out of your budget.

However, it’s not quite that straightforward.

The issue is that, because the value of your cash increases, you are more incentivised to hold onto your money rather than spend it. Also, when prices fall there is the expectation that this will continue, and a coveted item may be even cheaper tomorrow. As a result, people hold off on making a purchase.

A downside of fewer products being bought is companies’ revenues falling. This can lead to higher rates of unemployment as businesses are forced to cut costs. The subsequent continued downturn in spending is known as a “deflationary spiral”.

What is stagflation?

Stagflation occurs when there is no economic growth and unemployment is rising, but there is still inflation in the system. In other words, your wages would be falling, but the price of goods would keep rising. It’s not an ideal environment for anybody! Stagflation tends to be the result of ‘bad’ or ‘cost-push’ inflation.

What is reflation?

Reflation essentially signifies the start of the inflationary cycle after a recession. It is often regarded as the opposite of disinflation. It shouldn’t be confused with full-blown inflation, which we have already outlined, as it tends to happen more gradually.

Reflation occurs when the economy starts to experience stronger growth in conjunction with rising prices. This can be caused by central banks injecting more cash into the economy through actions such as reducing taxes, printing money, or lowering interest rates.

The idea is that as economic growth improves, demand for goods increases, companies make more products, and more staff get hired. Another positive of this backdrop is that it should lead to higher wages as companies continue to thrive.

Reflation also benefits the government because, as corporate profits improve and more people return to the workforce, they receive more tax revenue. As an added bonus, the government should also spend less money as benefit payments fall.

This article was originally published 13 March 2018. It was updated on 16 July 2020, 18 March 2022 and 2 May 2023.