The Economy: 1. Inflation

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Welcome to Understand the Economy, the podcast that takes you back to basics and explains the way economics affects our everyday lives.

You'll find all of our episodes on BBC Sounds.

Today we're talking about inflation, why prices go up, why they rarely seem to come down and how this affects you.

Inflation is a process where prices rise, not just the price of a pint or the price of an iPhone, but a generalised rise in prices for almost everything including, thankfully, your hourly wage or your annual salary.

Inflation affects you directly when you go to the shops and bread is more expensive than the last time you were there.

Or if your energy bill has gone up by a lot, this will affect you too.

But how is inflation calculated?

That job is left to some lucky people at the Office for National Statistics who go shopping for us.

Darren Morgan is the Director of Economic Statistics Production and Analysis at the ONS and he told me how they calculate inflation.

We do that by using a virtual basket of typical goods and services bought by households and we do that every month.

And that ranges from bread, gas electricity and holidays so very wide ranging so we collect prices every month and it's a really large exercise we collect around 180,000 price quotes for around 730 goods and services and we do that by visiting 20,000 shops in about 141 different locations in the UK and we have close to 300 people around the country visiting all types of shops from the largest supermarkets to the smallest corner shop to collect these prices.

And then at the end of the day or week, they send those prices over to us in the Office for National Statistics.

And then essentially, we put it through our system and it creates average prices.

So it tells us how much of that price of that good have changed from last month to this month and also a year ago.

And basically, we look at how much that average price have changed.

And that is your inflation rate.

How much prices are going up or going down?

Of course, we do change our shopping habits.

So each year, they add new items and they take out unpopular items.

Recent additions or removals from the basket, actually, are very much linked, as you'd expect, the impact of COVID.

So, additions include hand hygiene gel and antibacterial service wipes, meat-free sausages, and canned pulses, pet collars.

We saw a lot of people having pets for the first time during the pandemic, and also casual clothing.

And this sort of relates to the move to home working where casual clothing became much more the norm.

And home exercise became very popular during the pandemic, and we think it's year to stay.

So, hand weights, sports bras, and crops also entered the basket.

But we've also taken some things out that are also related.

Things like staff restaurant sandwiches, staff canteens are not as popular as they once was, again, because of home working, and men's suits.

We took that out of the basket.

Again, casual clothing seems to be a year to stay, whether that's at home or in the office.

Darren Morgan of the ONS.

Richard Davis is economics professor at Bristol University and director of the UK's Economics Observatory.

Hello, Richard.

Hello.

So meat-free sausages are in, pets are in.

Did you get a pet during lockdown or go veggie?

I didn't get a pet, but we did welcome twins into our family two or three days into lockdown.

Congratulations.

Yeah, so our spending shifted significantly with many more nappies and kids' clothes and so on.

Well that brings up a very interesting question then.

So I'm sure nappies and kids' clothes are in the basket of goods, but they were very much in your basket of goods and they weren't in mine since my youngest child is 11, fortunately hasn't been in nappies for a while.

So your inflation basket is different from my inflation basket and they're both different from the Office for National Statistics inflation basket.

So what should we make of that?

You're completely right.

The inflation rate that the ONS aims at is aimed at a kind of imaginary person who's the average of all of us.

And of course, nobody is like that.

There are going to be really important differences.

Pensioners for example have very different spending patterns to students and it means that everybody in truth is going to face their own individualized inflation rate.

And it's often said

that the rate of inflation for poorer households is higher than the rate of inflation for the typical household.

Do we know whether that's true?

We do think that on average poorer households are going to have a tougher time when things become more inflationary and that's because they have fewer choices to make.

There are necessary things that they spend on and let's take the most important examples which would be food and energy.

Everybody needs to heat their house and everybody needs to feed their family and those two parts of the basket take up a greater share of their income each month.

And so if you spend more of your total income every month on food and food is really facing a high inflation rate then your inflation rate is going to be quite a lot higher.

Time for for a bit of history.

When did we first notice inflation?

Here's Dr.

Victoria Bateman, economic historian at Cambridge University.

So probably the most recognizable price inflation in history came in the 16th century.

So by 1492, Christopher Columbus has sailed across the Atlantic Ocean and identified this whole new continent that Europeans didn't really know about beforehand, and that was the Americas.

And Columbus and his whole group of explorers returned to Spain with stories of great rich empires, stories of El Dorados on offer in South America.

They send fleets of ships across the oceans and these contain not only explorers, they also contain military.

And these military men conquer these great empires.

And what do they do with the inhabitants of these empires?

They enslave them and they put them to task to work in silver mines.

And perhaps the biggest silver mine that the Spanish discover was called the Potosi mine, a literal mountain of silver.

And sadly, thousands of local inhabitants are enslaved to do back-breaking work extracting this silver from this giant mountain.

So let's take a typical Spanish merchant returning home to Spain with this abundance of silver coins on board his ship.

What's he going to do with those silver coins?

Well, he's going to take them to the shops.

He's going to spend on wine, on fancy fabrics.

So with all of these extra silver coins coming into the Spanish economy, each coin is in a sense becoming less valuable.

These silver coins are becoming really common.

Everyone has them bulging out of their pockets.

And so because each coin is worth less, you're going to have to charge people more.

You're going to have to demand more silver coins in return for each of those items that you're selling.

And so the prices of goods are rising fast.

So, this price inflation that Spain is experiencing, in a sense, crucifies the economy.

Because now that goods and services are more expensive in Spain, fewer people abroad want to buy Spanish goods.

So, if you're exporting, say, cloth or Spanish furniture or Spanish wine, you have far fewer customers.

Thanks, Victoria.

We'll hear a lot from her throughout the series.

So Richard Davis, what causes inflation?

Well one reason could be that costs rise.

During the pandemic one thing that we saw was a big increase in the price of timber.

The reason for that was that lots of shops were shuttered.

They were not able to deal with their customers, bars, restaurants and so on.

And many people used it as an opportunity to improve their premises.

So there's this huge pickup in demand for construction services.

And one of the main things that builders use is timber.

So you had all these builders across the world calling lumber yards.

The lumberjacks are working as fast as they can, at the rate they can, and there's a certain amount of lumber coming into the yard.

But suddenly builders are asking for more and more timber to make all these home improvements.

And so there's physically just not enough wood in the lumber yards to meet all of this demand.

And so the people running timber yards are faced with all of these competing customers who are desperate to get hold of the timber and entrepreneurs as they are they put up their prices.

That higher price for wood then feeds through to everything.

So if you're making an improvement at home, if you're refitting out your shop or if you're making pencils, all of those things that include that raw material are likely to rise.

That's sometimes called cost-push inflation, but that's quite different to what we heard in the historical example from Victoria Bateman.

She was describing this flood of silver.

So there was literally more money in the economy.

There were more coins in the economy.

So it wasn't that there was a particular shortage of anything in particular.

It was just there was loads of silver.

So is that different to the timber example?

That would be different.

That's a situation in which there's lots of money in the system and demand in general in the economy is likely to be higher.

As we talk in late 2022, it does seem as though things are changing.

But over the past few years, we have had, a little bit akin to this historical example, a lot of money in the economy.

And that's to do with something called quantitative easing, which is the injection of new cash into the economy by the Bank of England.

And the result is that households and firms tend to be able to access cash via loans more easily.

And the result of this is that spending, so everything from my spending in the shops to the shops themselves investing in better machinery, a better fleet of cars to deliver their goods and so on, goes up.

And the overall demand in the economy goes up.

And and people tend then those selling goods those selling services raise their prices and so instead of enslaving a whole bunch of people and forcing them to mine silver from the new world

the bank of england thankfully doesn't do that but it can basically just push a button add some zeros to a spreadsheet somewhere and it's got more money because it's the Bank of England.

It's just allowed to do that.

And then it uses that money that it just magicked up to buy other things.

And in that way, just as the silver coins spread out across Europe, the money that the Bank of England has created spreads out into the rest of the economy.

So it didn't work out for the Spanish.

And now we're worried about inflation in the UK.

So why would the Bank of England have ever done that?

To try and revive the economy, because they want to try and hit an inflation rate of 2%.

And that's the really important point.

We don't think that we should have no inflation in the economy.

We think we should try and target a low and stable rate of inflation.

And it was looking like inflation was actually going to be too low.

That is going to sound very weird to most people.

Why don't we just want inflation to be zero?

Why don't we just want prices to be stable?

Why would you say, oh, we want a bit but not too much.

We want 2% inflation?

The reason is that imagine you're going for a walk at the coast and you're walking along a cliffside.

Do you walk right up against the cliff or do you walk a couple of meters away from the cliff edge?

And the point is that the other side of zero, so so negative inflation or falling prices, is seen to be much more costly than an inflation rate of say two, three, four percent.

And why is that?

Because if I expect that prices next month, next year are going to be lower for cars, for televisions, for anything, I'm going to hold off my expenditure.

So the doomsday scenario is something bad happens, economy is hit, it gets weaker, prices start to go down, but then everybody says, hold on, I'm not going going to buy anything.

Prices are going down.

And you get this double hit from the way people react to prices.

So we don't want falling prices.

And because of that, something like 2%, 3, 4% is seen as a sensible target.

And falling prices is called deflation.

Deflation, yeah.

So the idea is that deflation of 5%

is really bad.

Inflation of 5% is merely annoying.

And therefore, rather than aiming for zero right in the middle,

we aim for plus 2%.

That's exactly right, yeah.

So, to avoid deflation, the Bank of England is asked to keep inflation at two percent.

So, how does it do that?

Or at least how does it try?

Find out next time.

Understand the Economy was presented by me, Tim Harford.

It was produced by Phoebe Keene and Drew Hindman, and the editor is Claire Fordham.

It was mixed by James Beard.

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Wealthfront is not a bank.

The APY on cash deposits as of December 27, 2024, is representative, subject to change, and requires no minimum.

Funds in the cash account are swept to partner banks where they earn the variable APY.