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Inflation is at a 30-year high – what does this mean for you?

With inflation now at 5.4 per cent, where are price rises steepest, what’s causing them, and how long will they last?

By Emma Haslett

The Consumer Price Index, the UK’s main measure of inflation, has reached its highest level since March 1992. The Office for National Statistics (ONS) announced this morning (19 January) that the CPI increased from 5.1 per cent last month, already the highest level in a decade, to 5.4 per cent in the 12 months to December. 

What is inflation?

Inflation describes how much the cost of living is increasing (if it’s decreasing, it’s known as deflation). In the UK, the main measure of inflation is the CPI. The ONS tracks the cost of living through the prices of items in a hypothetical “basket of goods” that includes everyday products and services. The most recent basket of goods included staples such as a large wholemeal loaf, a roasting joint, olive oil and ice cream, but also added new items, such as hand sanitiser and smartwatches. Ground coffee, Axminster carpets and a 9-carat gold chain were removed.

Why is inflation so high?

The ONS said the main reason inflation rose so fast in the year to December was the cost of housing, which rose 1.3 percentage points, and transport costs – which were fuelled by the price of petrol. Average petrol prices in December were 145.8p per litre, up from 114.1p a year earlier, and the highest average price ever recorded

Energy prices have also rocketed recently (and many suppliers have gone out of business) because of constraints in gas supply, which the ONS said have resulted in price rises of 18.8 per cent for electricity and 28.1 per cent for gas in October, November and December, the highest annual rates since 2009.

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Second-hand cars were another factor: prices have risen because the global shortage of semiconductors has slowed production of new cars. The ONS said their “upward effect” on prices rose to 0.34 percentage points in December, “the largest contribution from second-hand cars” since it began collecting data in 2006.

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Meanwhile, the upward effect from restaurants and hotels fell back. In November, the sector made a 0.38 percentage point contribution to the overall inflation figure, its largest since October 2018. In December, that fell to 0.07 percentage points. But venues continue to face staff shortages, meaning they are competing on wages – so expect prices to continue rising.

These can all be put down to demand outweighing supply – shortages that develop either because there isn’t enough of something, or because everyone wants it.

[See also: What’s driving the UK’s cost of living crisis?]

What does high inflation mean for interest rates?

Interest rates and inflation are often mentioned in the same breath because interest rates are one of the ways central banks (the Bank of England in the UK) can try to limit price rises. The Bank of England’s target is to keep inflation around 2 per cent: any higher, and the cost of living becomes very expensive; any lower and prices (and wages) stagnate.

Traditionally, central banks increase interest rates when inflation is high. That means borrowing becomes more expensive, and people and businesses are rewarded for saving, so spending falls, reducing demand and causing prices to drop.

In November the Bank of England said it expected inflation to keep rising to about 5 per cent by April, so it’s rising much faster than economists had predicted. Some analysts expect the Bank of England’s base rate to rise to 0.5 per cent in February, climbing to 1 per cent by the end of the year.

[See also: The big risk to Boris Johnson isn’t Labour – it’s inflation]

Will high inflation cause house prices to fall?

Inflation is essentially the measure of how much of something a currency can buy. In the short term, rising prices of materials such as timber may mean that the price of new builds rises slightly.

But UK house prices have been enjoying an uninterrupted rally since a dip just after the sub-prime mortgage crisis in 2008. That’s because the government has used a range of methods to provide cheap debt (or even free debt, in the case of the Help to Buy scheme), ensuring the housing market has been kept more or less constantly buoyant.

The one thing that could interrupt this would be an interest rate hike by the Bank of England, which would push up mortgage rates. But even if the Bank does hike interest rates, it would have to be a significant rise: at the moment, the base rate is at just 0.25 per cent, compared with 0.75 per cent before the pandemic.

Is this spike in inflation transitory?

The Bank of England has previously insisted that post-pandemic inflation is “transitory” – a temporary rise in prices brought on by the supply chain constraints created by lockdowns and staff shortages. That argument is being used by central bankers on both sides of the Atlantic.

Some economists don’t agree: the supply chain constraints created by the pandemic are likely to continue for much longer. The rise in car prices, for instance, is likely to carry on for a while – the chief executive of Daimler has said the chip shortage could last well into 2023, meaning the price of second-hand cars will continue to stay high. In November, gas prices soared by 17 per cent in a day.

But at a session of the Treasury Select Committee on 15 November, Bank of England governor Andrew Bailey insisted it was short-term inflation: “We have had a period of goods-intensive demand, because some important parts of the service sector have effectively been closed down. That rebalancing is happening, but not as rapidly as we probably thought it would. That of course is putting strain on the supply chain system,” he said.

So do I need to start panic buying?

Inflation is going to keep rising this year, the IMF has said – so prices will keep going up. But panic-buying will only increase demand while supply stays the same, causing prices to rise even faster, so for now, keep your hoarding to a minimum – or, dare we say it, buy less.

[See also: Gary Stevenson: “I knew the markets were wrong”]

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