Inflation Explained: What It Is, How It's Measured and Why Prices Rise
A plain-English guide to inflation: how the CPI works, what pushes prices up, why central banks aim for around 2% and what it means for your savings and spending.
Inflation is the rate at which prices for goods and services rise over time. When it is high, each dollar or pound buys less than it did before. When it is low and stable, it barely affects daily life, which is why central banks work to keep it in check.
How inflation is measured
Statistical agencies track the cost of a typical “basket” of things households buy, such as food, housing, transport, clothing and energy. The change in the basket’s cost from one year to the next is the inflation rate.
- In the United States, the Bureau of Labor Statistics publishes the Consumer Price Index (CPI). The Federal Reserve also follows the Personal Consumption Expenditures (PCE) price index.
- In the United Kingdom, the Office for National Statistics publishes the Consumer Prices Index (CPI), which the Bank of England targets.
You will often see two versions: headline inflation (everything) and core inflation, which excludes food and energy because their prices can swing widely from month to month.
Why prices rise
Economists usually point to a few main causes:
- Demand-pull: people want to buy more than the economy can supply, so sellers raise prices.
- Cost-push: businesses face higher costs, such as wages, raw materials or energy, and pass them on.
- Supply disruptions: shortages of goods or shipping problems push prices up.
- Expectations: if people expect prices to keep rising, they may ask for higher wages and firms raise prices in advance, which can keep inflation going.
Why central banks aim for about 2%
The Federal Reserve, the Bank of England and many other central banks target inflation of around 2% a year. They use interest rates as their main tool: raising rates makes borrowing more expensive and cools spending, while cutting them does the opposite. Very high inflation hurts savers and people on fixed incomes, and makes planning harder for businesses. Falling prices (deflation) can be a problem too, because people may delay purchases.
How inflation affects you
| Group | Typical effect of higher inflation |
|---|---|
| Savers with low-interest accounts | Their money buys less over time |
| Borrowers with fixed-rate debt | The real cost of repayments falls |
| People on fixed incomes | Spending power drops |
| Workers | Better off only if pay rises faster than prices |
What you can do
- Compare savings accounts and look for rates that keep pace with inflation.
- Review regular bills and subscriptions often, as prices can creep up.
- Consider inflation-linked products where available, such as Treasury Inflation-Protected Securities (TIPS) in the US or index-linked gilts in the UK, and understand their risks first.
- Build an emergency fund so that price shocks are easier to absorb.
This article is general information, not financial advice.
Frequently asked questions
Is some inflation good for the economy?
Many central banks aim for low, stable inflation of around 2% a year. They argue it gives room to cut interest rates in a downturn and avoids the risk of falling prices (deflation), which can discourage spending.
What is the difference between headline and core inflation?
Headline inflation covers all items in the price basket. Core inflation leaves out food and energy, which swing sharply, to show the underlying trend.
Does inflation mean my wages are worth less?
If your pay rises more slowly than prices, your purchasing power falls. If pay rises faster than prices, you are better off in real terms.
