Economic environment: Inflation

Data from Timetric.To view this graph, please install Adobe Flash Player. Inflation: Headline indicators, UK from Timetric

Inflation is the tendency for the price level to drift up through time. Things tend to get more expensive, on average, as the years go by. After a quiet spell from the mid 90s to around 2005, inflation stayed subdued - but it seems to be making a comeback. What does that mean for business?

The simplest thing you can say about inflation is that it is likely to drive up the costs firms face. If they are going to defend their profits, they will need to increase prices (or find cost efficiencies from somewhere). In the current economic environment it may prove tricky to raise prices, if customers are sensitive to price changes (this issue is discussed through the concept of price elasticity of demand).

If you want to develop your understanding of inflation, you could consider the following points:

- The Bank of England tries to discourage inflation from taking root. Inflation tends to build up when there’s too much demand in the economy. To prevent that happening, the Bank of England uses monetary policy – control of short term interest rates – to manage demand. If inflation looks like it is going to stay above the target level of 2%, the Bank will increase interest rates. That’s a move designed to discourage borrowing/spending and encourage saving in order to reduce the total level of demand in the economy.

- Inflation is only an average measurement of the price level. An index like the Consumer Price Index (CPI, used in the chart above) tracks price changes in a broad ‘basket’ of goods. But of course some prices rise a lot faster than average, whilst others may even be falling. That means that inflation might be rising by X%, but some firms may experience cost increases that are much more significant than that figure. Other firms may be much less affected. You’ll be aware that the most serious price pressure in the economy at the moment is coming from higher petrol and food prices. That’s a massive headache for some firms – but not all.

- Think about how consumers are affected by inflation. At the moment, they are feeling a squeeze. A higher price level isn’t such a problem if wage increases match the increase in the price level. But at the moment, they aren’t. Most households are poorer now than in 2008 in ‘real’ terms– because pay packets haven’t grown as fast as prices.

The Economist has a nice article about measuring inflation and current supermarket offers here.