What Is Inflation and How Does It Affect Your Money?
Inflation is the rate at which the general level of prices for goods and services rises over time — and consequently, the rate at which your money's purchasing power falls. A pound today buys less than a pound did ten years ago, and will buy less still in ten years' time.
How Inflation Is Measured
In the UK, inflation is primarily measured by the Consumer Prices Index (CPI) — a basket of around 700 commonly purchased goods and services, from food and clothing to rent and cinema tickets. The Office for National Statistics tracks how the price of this basket changes month by month. The US equivalent is also called CPI, tracked by the Bureau of Labor Statistics.
A related measure, the Retail Prices Index (RPI), includes mortgage interest payments and is often used for wage negotiations and index-linked savings. CPIH is a newer variant that includes owner-occupiers' housing costs.
What Causes Inflation?
Demand-pull inflation occurs when demand for goods and services exceeds supply — too much money chasing too few goods. This often happens during economic booms or when central banks keep interest rates very low for extended periods.
Cost-push inflation occurs when production costs rise — raw materials, energy, wages — and businesses pass those costs on to consumers through higher prices. The energy price spikes of 2021–2022 were a clear example.
Built-in inflation is a feedback loop: workers expect prices to rise, so they demand higher wages, which increases business costs, which leads to higher prices, which leads to further wage demands.
The Real Impact on Savings
If inflation runs at 3% per year and your savings account pays 1% interest, your money is effectively losing 2% of its purchasing power annually. After 10 years at those rates, £10,000 would only buy what £8,171 buys today.
This is why keeping large amounts of cash in low-interest accounts is considered poor financial planning in inflationary environments. The money feels safe because the number doesn't decrease — but what it can actually buy does.
Hyperinflation — When It Goes Wrong
Extreme inflation — hyperinflation — occurs when prices rise uncontrollably, often due to governments printing money to cover debts. Weimar Germany in 1923 saw prices double every few days. Zimbabwe experienced 89.7 sextillion percent annual inflation in 2008. In both cases, currency became effectively worthless.
These are extreme examples, but they illustrate the fundamental principle: inflation is ultimately about confidence in a currency and the goods that underpin its value.
How Central Banks Respond
Central banks — the Bank of England, the Federal Reserve — primarily control inflation through interest rates. Raising interest rates makes borrowing more expensive, which reduces spending and investment, which cools demand, which eases price pressure. The target for most major economies is around 2% annual inflation — enough to discourage hoarding cash, not so much as to erode savings meaningfully.