Picnic for a pound: inflation, purchasing power, and the CPI

Inflation is when prices for goods and services increase over time. Deflation is when the opposite happens, and prices go down. When inflation rises faster than the amount of money you have to spend, there’s a conflict. You get less bang for your buck (or less sandwich for your pound), because your purchasing power is reduced. 

Who decides how much purchasing power your £10 note gives you? The simple answer is that the markets decide. In this context, a market is anywhere cash is exchanged for goods or other assets, whether that be a stock exchange, a bank, an electricity company, or a pet shop. 

But of course, there’s far more to it than that. The purchasing power of a £10 note is influenced by world events, governmental decisions, consumer confidence, cultural trends, and even the weather (for example, if onion harvests are poor due to bad weather, the supply of onions will decrease hence onions may cost more in the shops).

The Consumer Price Index (CPI) tracks the cost of an average shop for a typical household to measure inflation and its impact on purchasing power. The CPI is run by the Office of National Statistics, which is the UK’s recognised national statistical institute.

The CPI tracks the prices of 700 items that make up the national shopping basket, including a broad range of products and services that consumers rely on, including food, utilities, travel, and leisure.

Even though everybody buys different things, the CPI does a good job of conveying the overall trend of inflation; including price changes, and the rate at which prices change relative to purchasing power.

The Family Resources Survey, led by NatCen on behalf of the UK Government, is another source of data on how the cost of living (including inflation and purchasing power) is affecting people across the UK.

Inflation doesn’t mean that prices continually rise at a steady pace, without ever falling back to previous levels. Instead, it’s about the overall tendency of goods and services as a whole, to cost more money over time.

Going back to the cheese from our example above, cheddar cheese was actually more expensive ten years ago than it is today – at £7.87/kg in July 2012, compared to 7.27/kg in 2022. This doesn’t mean that everything is cheaper today than it was in July 2012. That’s because cheese isn’t the only thing in our shopping baskets.

When inflation drives up the cost-of-living, the idea of prices falling (deflation) may seem attractive. However, deflation brings problems of its own. Like inflation, deflation isn’t about occasional price drops – bargains, for example. It’s about a sustained trend over time.

Deflation can lead to reduced profits for suppliers, and impact negatively on the wages employers are able (or willing) to pay. It can also leave consumers with negative equity - a scenario in which you owe more on your house (for example) than it is currently worth. 

Individual citizens can’t directly bring down inflation or boost purchasing power.

Inflation impacts different groups in different ways, so your options for adjusting your household cash flow will depend on how much room for manoeuvre you have in your budget. 

Having an emergency savings fund can help cushion the impact of inflation and other difficult times.

Keeping inflation at the target rate is the job of the Bank of England, but it can’t single-handedly bring inflation down. The UK Government sets an inflation target for the Bank; currently it’s 2%. The goal is to maintain some level of growth, without letting the rate of inflation rise so far that it causes problems in the economy (including the cost of living).

When global inflation-driving forces like war, pandemics, and supply chain problems can’t be defeated, the Bank’s main tool for controlling inflation is through what’s known as the Bank Rate – perhaps more commonly known as the ‘base rate.’

The base rate is the rate of interest at which the Bank of England lends money to other banks in the country. A low base rate may encourage higher rates of borrowing, and can lead to more money flowing within the economy. A higher base rate may have the opposite effect, and perhaps even incentivise saving and investing, with the possibility of earning higher returns.

Individual banks set their own interest rates, and may change these when the Bank of England adjusts the base rate.

When the rate goes up, you’ll usually earn more on any cash savings (provided the account has a variable interest rate); but if you have a mortgage, your monthly payments could be more expensive. 

For a sense of how interest rates can change, take a look at the historical interest rates and bonus rates we’ve offered to our Marcus by Goldman Sachs savings customers.