Inflation has a huge impact on our money and how far it goes. Here's an overview of what inflation is, how it works, and how it affects you.
“Inflation” is a very important banking term. But it can seem quite confusing at first.
You've probably heard it on the news and thought: But what exactly is inflation and how does it affect me? This guide is here to answer.
Below, we'll go over some key inflation information to help you better understand how changing exchange rates affect you.
What's in this inflation guide?
the meaning of inflation
How is inflation measured?
What causes inflation?
What is the Bank's interest rate?
What is deflation?
How does inflation affect you?
What does inflation mean?
Inflation refers to the general increase in prices . The inflation rate compares what it is worth now compared to a year ago.
With inflation, you generally get less for the same money as last year.
There are over 700 commonly bought items in the UK that are controlled for inflation. These include everyday essentials like food as well as some big ticket purchases like cars.
How is inflation measured?
UK inflation rates are measured by looking at:
- Consumer Price Index (CPI)
- Consumer Price Index Including Housing Costs (CPIH)
- Retail Price Index (RPI).
Here's an overview of what these terms mean.
Consumer Price Index (CPI)
The CPI is essentially the value of the average person's “shopping basket.” There are many products and services that are studied to calculate the CPI.
CPI inflation hit the headlines in July 2022 when it was announced that it had risen to 9.4% in June. This is the last 40 years.
Consumer Price Index including housing costs (CPIH)
The CPIH is very similar to the CPI, except that it also takes into account the housing costs of homeowners.
Factors such as mortgage payments and council tax can inflation.
Retail Price Index (RPI)
Often when inflation is discussed in the news, the focus is on the CPI and HSPI. RPI inflation usually no longer carries that much weight. But it is still important especially students.
The RPI, like the CPI, focuses on a ‘shopping basket'. However, some products and services in the RPI basket are slightly different from those in the IPC. Because of this, their inflation rates tend to differ.
The RPI has a major impact on student/graduate debt. Student loan interest rates are generally based on the March RPI reading of each year.
Each September, the March RPI figure for that year is usually used to determine student loan interest rates.
The way student loan interest rates are determined varies across the UK. We'll explain this in a bit more detail later.
What causes inflation?
Here are some examples of factors that can affect the inflation rate:
- Increase in demand for goods or services. If more people buy the same product or service, prices can rise to match the increased demand.
- Limited supply of goods or services; When goods or services are in limited supply (such as gas or oil), prices are likely to rise.
- Increase in the cost of materials. If production costs increase, the product is likely to become more expensive as a result.
- Wage Increases – When companies increase the amount paid to their workers, this often results in an increase in the cost of their products.
- Policy changes. Sometimes the policies presented by the government can affect the inflation rate. For example, if the tax on certain goods is lowered or raised, it can affect consumer prices. Also, if the price of a product falls due to a tax change, consumers may buy more. As we mentioned in the first point, an increase in demand can lead to an increase in prices.
Inflation is also affected by Bank Rate. This is a benchmark set by the Bank of England to influence inflation by deciding how high interest rates should be on things like savings accounts and credit cards. We will explain in more detail point…
What is the Bank Rate?
Bank rate is set by the Bank of England with the aim of inflation. You may also hear it called the Bank of England base rate.
Currently, the Bank's interest rate is 1.25%.
The government sets the Bank of England a goal of keeping CPI inflation at 2%. And to achieve this, the Bank of England sets the bank rate to decide how much interest banks should charge for things like savings accounts and credit cards.
In general, to determine the bank rate, the Bank of England takes into account the likelihood that people will borrow or save based on interest rates.
If, for example, interest rates are high, it will be easier to save money than to borrow money. When it's harder to borrow money, it can reduce spending and reduce the rate of inflation.
On the other hand, if interest rates are low, it will be easier to borrow than to save. This can increase costs and increase the inflation rate.
However, it is not as simple as saying that when the rate of inflation is high, the Bank Rate will be high to encourage people to save rather than spend money. While a higher bank rate could theoretically reduce the rate of inflation, there are other potential problems for the Bank of England to think about.
The important factor is that if people start spending much less, many companies will make less money as a result. And if companies earn less, that could lead to some employees losing their jobs.
So the Bank of England has to be very careful how high or low it sets the bank rate.
If you have a Plan 1 or Plan 4 student loan, Bank Rate can be used to determine your interest rates. That would be the low of Bank Rate and RPI for March of the same year (more on this later).
For more information on Bank Rate and how it works, visit the Bank of England website.
What is shrinkflation?
A discount is when the price of a product stays the same, but it is reduced in size or quantity, meaning you get less for the same amount.
Some brands may be reluctant to raise the price of a product. Customers will likely notice the change and be disappointed with the new value.
So instead of raising the price, brands can choose to make the product smaller. This may be more difficult for the customer to detect.
When you go shopping, try to keep an eye out for inflation.
An easy way for food to see if it has shrunk is to check the weight of the packaging. A bar of chocolate that used to weigh 100g but now weighs 95g, even though it costs the same, would be an example of contractionary inflation.
How does inflation affect you?
Here are five ways inflation can affect you:
1.Cost of living
Inflation is the rate of increase prices of goods and services. If wages generally rise at the same rate as inflation, it will help keep people from keeping up with the rising cost of living.
Unfortunately, this is not always the case.
As we already mentioned, inflation actually means that the same amount is worth less compared to the previous year. So if inflation rises but your income stays the same, your income will lose value.
The problem of inflation and income growth at different rates has contributed to the cost of living crisis.
2.Student Loan interest rates
Inflation plays a big role in determining student loan interest rates. Interest rates change every September and generally stay the same until the following August.
Here's a quick overview of how interest rates work depending on which plan your student loan is on:
- Plan 1 loans. the rate will be the lower of March RPI or Bank Rate plus 1% in the same year.
- Plan 2 Loans – While you're studying (and until April after you complete your degree), the interest rate will be RPI from March of the same year plus 3%. From April after you leave college, it varies from RPI to RPI plus up to 3%, depending on your income.
- Plan 4 loans. the interest rate will be the lower of March RPI of the same year or Bank Rate plus 1%.
Not sure which plan you're on? Find out in our Student Loan Repayment Guide.
Sometimes, if the RPI is too high, the government sets interest rates at a lower rate.
For example, RPI inflation in March 2022 was 9%. If the government calculated interest rates the standard way, it would mean that current students and higher-income graduates with Plan 2 loans would face 12% interest.
Many (including us at Save the Student) called on the government to clarify whether interest rates would actually go that high.
In response, the government announced in June 2022 that interest rates would be capped. Now, all students and graduates on Plan 2 loans will have an interest rate of 7.3% starting in September 2022.
3.Maintenance Loan amounts
The maximum amount of maintenance credit available increases each year. This is designed to help you keep up with the rising cost of living.
However, the Institute for Fiscal Studies (IFS) has warned that credit is not growing enough to keep up with inflation.
And, worryingly, in our latest National Student Money Survey, we found that the average student's maintenance loan was £340 less than their living costs every month.
Therefore, we believe that the government should increase loan amounts to ensure that they cover students' living expenses, even before inflation is taken into account.
If you find your service loan is too small, you can search for scholarships, grants and subsidies to see if you qualify for any additional funding.
Part-time work can also help you keep up with living expenses.
And if you're looking for more ideas, check out these ways to make money fast.
4.Interest rates on savings accounts
As we have already mentioned, the bank interest rate has a great influence on the interest rates.
The main reason to keep cash in savings is to grow your money. However, if your savings account has a lower interest rate than current UK inflation, your money will continue to lose value.
This can be difficult to avoid.
At the time of this writing, savings accounts generally have fairly low interest rates compared to the rate of inflation.
You can usually get higher interest rates with time savings accounts compared to easy access. However, you may still find that there is a large gap between the interest added to your savings and the rate at which the cost of living increases.
However, that doesn't mean you shouldn't try to save money. If you can increase your money, even a little, this is better than nothing.
5.Credit card interest rates
Continuing from the previous point, inflation can affect the interest rates offered by banks for credit cards. This, again, is linked to the bank rate, which is set by the Bank of England to influence the rate of inflation.
When interest rates are high, it means that people will generally be less likely to borrow and more likely to save. So if the Bank of England decides that a higher bank rate will help stabilize inflation, it will make it more expensive to borrow.
So you may find that your borrowing habits are affected by the current rate of inflation in the UK.
But remember. it's always important to be careful with credit cards. Even if interest rates are low, you still need to be sure you can make your payments on time and in full each month. If you miss a payment, your credit score can be affected.
For more information, including risks to be aware of, check out our complete guide to student credit cards.
If you're struggling with living expenses and need emergency cash, see if you can access your college's emergency funds.