What is inflation and how does it affect the cost-of-living crisis?

AFTER 20 years of being quiet background noise, inflation has spent 2022 slashing the country’s standard of living. So, what is it? How do we control it? And does it affect people differently?

What is inflation?

Inflation is an increase in the price of goods and services over time. This happens either because the amount of money being spent increases, known as demand-pull inflation, or because the number of goods and services falls, in what’s called supply-push inflation.

One way to explain this is by thinking of demand as butter, goods as toast and prices as butteriness.

If you keep the amount of butter the same and reduce the amount of toast, what remains becomes more buttery. The same thing happens you increase the amount of butter but hold the quantity of bread constant.

The former would be demand-pull inflation, the latter supply-push.

This distinction matters as it affects how policymakers respond.

With demand-pull inflation, the government has to reduce the amount of money that people are able to spend. There are two main ways that it does this.

First, it can cut the amount it spends and increase the amount it takes in taxes. The impact of this depends on where the cuts happen and which taxes go up, but the general effect is that the amount of money in the economy falls – the toast becomes less buttery.

Secondly, the Bank of England can step in. Since 1997, the bank has controlled monetary policy. This covers a few things, the most important being control of the base rate.

This is the interest rate that the Bank of England charges on the money that it lends to commercial banks and, as such, it affects rates throughout the economy.

If the Bank of England chooses to raise rates, it makes borrowing money more expensive and saving more profitable. This makes spending harder and reduces demand.

Supply-push inflation is a lot harder to deal with as it happens because of a real shortage of goods in the economy. To prevent inflation, policymakers either have to increase the number of goods or reduce the amount of demand. The former is tricky in the short-term, the latter involves accepting a real drop in the standard of living.

Why is it important to control inflation?

Inflation isn’t always a problem; the Bank of England usually aims for a rate of 2%. It really becomes an issue when price rises outpace pay increases, as people’s standard of living then starts being eroded.

This is the situation we’re in at the moment. The Consumer Price Index, a statistic that estimates prices for the average household, went up by 11.1% in the year leading up to October while income only grew by 6%.

Inflation has spent the year moving away from its 2% target

It’s also important to control inflation as it can have a nasty habit of driving itself. There are two main ways this can happen. Firstly, if people expect prices to go up in the future, they are more likely to spend money now. This increases demand without necessarily increasing supply, potentially creating a self-fulfilling prophecy.

The second is what’s known as a wage-price spiral. Basically, if workers demand higher wages, companies may choose to pass on the extra cost to consumers by bumping up prices. If this is widespread enough, workers may ask for further wage rises and so on and so on.

Both of these explanations are purely theoretical. Higher wages do not necessarily raise prices, especially if there are significant profits that can be eaten into instead.

The existence of inflation also does not guarantee an increase in people’s expectations of future inflation. This why you hear Andrew Bailey, the governor of the Bank of England, repeatedly state with certainty that he will get inflation down to 2%.

To borrow a term from the self-help community, he’s literally trying to manifest lower inflation by reducing inflation expectations.

There is, however, debate about whether we could sustain a level of inflation above 2%. While current levels are too volatile, some economists argue that we may be able to bear something closer to 4%.

If so, policy response may not have to be as extreme. This matters because the consequence to the government dealing with inflation is the infliction of economic harms like public service cuts and higher unemployment. The less severe the response, the less these harms are inflicted.

What kind of inflation does the UK have?

In Autumn 2021, when inflation started rising above its target rate of 2%, most of the pressure was coming from the supply side. This was because the global economy got smaller during the pandemic. As people worked less, the amount of stuff we produced shrunk – leaving us with a similar amount of money, spread over fewer goods.

This was especially true for energy. During the pandemic, the prices of commodities like crude oil collapsed as people stopped travelling, meaning that suppliers had to reduce production. As lockdowns eased, demand returned to normal levels causing the price of the contracted supply to rise.

This was worsened in February 2022, when Russia invaded Ukraine. Vladimir Putin sought to leverage his outsized grip on Europe’s energy supply by cutting off Ukraine’s allies, causing prices to rise even further. The higher cost of energy then bled into the price of other goods, especially food, as it became more expensive to produce them.

The problem with supply-side inflation is that there’s very little governments can do about it in the short-term. When prices are going up because of a real shortage of goods, it’s inevitable that there will be some fall the standard of living. The best policymakers can do is ensure that this drop is equitable, in that it falls on shoulders of those most able to bear it.

However, as 2022 has gone on, there have been growing concerns that inflation is also being driven by higher demand. Core CPI inflation – a measure that excludes goods affected by supply shortages like energy and food – was around 6.5% in October, well above the Bank of England’s target of 2%.

There are a couple of explanations for this. Firstly, the UK’s labour market is the tightest it’s ever been. A combination of Brexit labour market frictions and Britons’ apparent hesitancy to return to the workplace post-pandemic has resulted in record-high vacancies and record-low unemployment.

This means that it’s really tricky for employers to find employees, putting workers in a significantly better place to ask for pay rises. If these pay rises get too high, we could see the wage/price spiral mentioned earlier.

This is why the Bank of England is now raising interest rates, up from 0.25% in December last year to the current level of 3%. The idea is that money simultaneously becomes more expensive to borrow and more profitable to save. In turn, this reduces both the amount that people spend, and the demand pull on prices.

How does high inflation affect me?

High inflation affects people both directly, through higher prices’ erosion of the real standard of living, and indirectly, through pain caused by policymakers’ response.

While the direct impact on households is fairly simple, its distribution is anything but. Of course, inflation means that you can buy less stuff with the same wage. However, because households buy different amounts of different goods – and prices are rising at different rates – the rate of inflation varies from person to person.

For example, in the two years leading up to June 2022, the wholesale price of unleaded petrol went up 88% – well above the average rate of inflation. This means that those who drive petrol cars experienced an inflationary pressure during that period that others didn’t.

And, because inflation has been significantly higher in the food and energy markets – both goods that make up a greater proportion of low-income households’ spend – it has consistently hit those that earn less harder.

In October, the poorest UK households faced inflation of 12.5%, while the richest only saw 9.6%

There are also geographic inequalities. Households in Wales and the North of England are both less insulated and less connected by public transport. This means that families in these areas are disproportionately on the hook when the cost of things like energy and petrol go up.

The ONS has a tool that estimates your own personal inflation rate here.

The second way that people are being impacted is through the measures being taken to control inflation. Interest rates are rising, up 2.75% in the last year, affecting everything from housing costs to credit card debt.

The Government is also tightening its spend. While we will see meagre increases to spending until 2024, the Chancellor has pencilled in public service cuts and tax rises for the three years after that.

The good news is that this seems to have eased fears of inflation, the Bank of England is now projecting that inflation will be down to 5% by the end of next year and as low as 1% at the end of 2024.

The bad is that the side-effects of these measures mean that the economy is set to shrink over the next two years. This means unemployment doubling to 6.4% by 2025, cuts to public services that are already on their knees and a significant fall in household income.

Events could alter these predictions in the medium term – not least the 2024 general election. However, as things stand, while the cost-of-living crisis was caused by inflation, it could also outlast it.