As businesses and individuals alike face the challenges of rising costs, it is important to understand the root causes behind these economic shifts. Inflation, the rate of increase in the price of goods and services over time, is a key factor to consider. In simplistic terms, if inflation is 10%, then that means it costs 10% more to buy certain goods/services than it did a year ago. So, when inflation rises, the purchasing power of our money decreases, making it more difficult to afford the things we need and want.
Inflation is measured in a few different ways, but one of the main measures is the Consumer Prices Index (CPI). CPI tracks the price of certain goods and services, which include a list of things from food, clothing, and household services. Typically, the Bank of England aims to hold the CPI level to around 2%.
Inflation is influenced by a range of factors, including supply and demand imbalances, increases in production costs, and geopolitical events that disrupt global markets. Inflation tends to rise when there is a demand from consumers that cannot be fulfilled, i.e., not enough supply. This increase in demand over supply leads to pressure to increase prices, and this is known as ‘Demand-pull’ inflation. The best example is to think of rare items and how they command a high price compared to common items, which are much cheaper.
Similarly, when producing goods/services becomes more expensive, then this can also drive up the cost. We have seen this recently with the hikes in energy cost, which has led to things becoming more expensive as the cost to produce them has gone up too. This type of inflation is called ‘Cost-Push’ inflation. Recently we have had the pandemic, Brexit, and now the conflict in Ukraine, all of which affect how easily we can access and produce goods/services. Understanding the different types of inflation, such as demand-pull and cost-push inflation, can help organisations anticipate and manage their financial risks.
So, how can we manage inflation? Well, the current levels of 10% are excessively high (in October 2022, we exceeded 11%, which is a 41-year high!) and way above the Bank of England’s target rate. One tool that central banks use to manage inflation is adjusting interest rates. Interest is the amount you would pay for borrowing money or what you could receive from saving money with the banks. Interest rates are shown as a percentage of the amount you borrow/save over a year period. For example, if you save £1,000 with your bank for a year, and the rate of interest is 1%, then you will have earned an extra £10 in the year, i.e., you will have £1,010 in your bank account at the end of that year.
By increasing interest rates, the Bank of England aims to reduce borrowing and encourage saving, which, in theory, should lead to less spending and, therefore, decrease the demand for goods and services and help bring inflation under control. However, this approach is only effective in managing demand-pull inflation, not cost-push inflation caused by production cost increases.
We have heard about the continual increases in interest rates, which have been increasing at 0.5% increments, but the good news is this is beginning to slow, and the forecast is for this to remain steady going forward. It is important to note that inflation is a complex issue, and there is no one-size-fits-all solution. Central banks must balance the need to manage inflation with the risk of economic recession. Organisations, too, must navigate the complexities of inflation and increasing costs to stay competitive and financially viable.
It is difficult to forecast what will happen with inflation, but it is expected to drop to about half its current level mainly due to the increases that have already happened (i.e., the increases in energy/goods/services for last year won’t be factored into the coming year’s calculation). However, the current prices of goods/services may keep inflation high for a bit longer.
At Peru, we understand the challenges organisations face in managing their finances in a rapidly changing economic landscape. Our team of experts can help you navigate these complexities, contact us today to learn more about how we can help.