What is inflation? How does it affect your money?

What does inflation mean?

Inflation simply means that prices are rising, and that goods and services are more expensive than they used to be. Higher prices reduce the “purchasing power” of your money, as the same sum of money can buy less than it used to.

For example, an average loaf of white bread cost around 52 pence in 2000 but, due to inflation, this same loaf costs around £1.40 in 2025, according to data from the Office for National Statistics (ONS).

This means that £1 could buy almost two loaves of bread in 2000 but, in 2025, the same amount couldn’t even buy one loaf.

When people talk about the cost of living and things becoming more expensive, this is often because of inflation.

What is the Consumer Price Index?

The Consumer Price Index (CPI) is a key measure of inflation. The ONS calculates the CPI every month by looking at the cost of a range of household goods and services.

The overall change in prices over the past year is portrayed as a percentage.

For example, if inflation is at 2%, this means that prices are 2% higher than one year ago. So, something that used to cost £1 would now cost £1.02.

Within this overall figure, individual items may have seen significantly higher price rises while others may have dropped in price. Moreover, individuals will be affected by inflation in different ways and may experience a higher or lower rate than the headline figure, depending on their situation and how they spend their money.

Nevertheless, CPI can still act as a useful measure of how prices are changing and for showing the overall trend.

What is the current inflation rate?

Inflation in March 2025 stood at 2.6%, down from 2.8% in February.

How is inflation measured?

To calculate CPI, the ONS tracks around 180,000 prices of approximately 700 items (often known as a “basket of goods”) to see how they have changed over time.

This includes a wide range of everyday goods and services , including:

• food
• clothing and footwear
• toiletries, personal care and cleaning products
• furniture, appliances and electronics
• recreational items, including books, toys and games
• transport costs, including car prices, fuel and public transport fares
• bills and subscriptions, including energy, phone, broadband and TV streaming services
• entertainment and activities, such as cinema tickets, gym memberships and days out.

Prices of these items are collected nationwide from different retailers to give a representative sample.

Different items and sectors are given different weights, depending on their importance in a standard household’s expenditure.

The ONS reviews this “basket of goods” every year, removing and adding different items to ensure it reflects the current spending habits of consumers.

For example, in 2025 , the ONS removed items such as newspaper adverts, oven-ready joints and in-store cafeteria meals in line with changing consumer preferences.

It also added a range of items including virtual reality (VR) headsets, exercise mats and men’s sliders as these have become more popular in recent years.

Note that CPI doesn’t include certain housing costs, including rent payments and council tax. The Consumer Prices Index including owner occupiers’ housing costs (CPIH) covers these costs but doesn’t include mortgage payments.

Reasons for inflation

There are many factors that can contribute to rising inflation at a particular time, but these can usually be covered under two broad reasons.

Cost-push inflation

This is when it costs businesses more to make goods or offer services, because of increases in prices of raw materials, for example. Businesses may pass on these increased costs to consumers by raising prices, making products and services more expensive.

Demand-pull inflation

This is when demand for a particular product or service is greater than businesses can supply, forcing them to raise prices.

Is inflation good or bad?

In moderation, inflation is a sign of a healthy economy as it can encourage economic growth and persuade consumers to spend their money (before prices rise any higher).

Currently, the Government has set a CPI rate of 2% as a healthy target for the economy, and the Bank of England is tasked with trying to keep inflation at this level. If inflation falls or rises more than one percentage point either side of this target, the Bank of England needs to tell the Government why.

It is only when inflation increases or decreases significantly more than this that it is deemed to have a negative impact on the economy.

For example, if inflation becomes too high and prices grow out of control, the cost of living can soar. Because the cost of essentials will be higher, without a similar rise in wages and benefits, consumers will have less disposable income which means they are likely to cut spending on non-essential items like holidays and eating out.

What about deflation?

Deflation (when prices are falling) can be just as bad as high inflation. While lower prices may sound good, it can have a negative effect on employment and the economy.

For example, if prices are falling, people may not spend as much because they want to wait until prices drop further. This means businesses could make less profit and, in an attempt to cut down on costs, may cut wages or make redundancies. This in turn could lead to higher unemployment and, if more individuals are finding money tight and spending less, businesses may need to lower prices even more to make any sales.

How does inflation impact interest rates?

Inflation and interest rates are linked as the Bank of England uses the central interest rate (or base rate) to help control the economy and inflation.

The base rate is set by the Monetary Policy Committee (MPC) and influences how much it costs to borrow, as well as how much interest is offered on savings accounts.

When inflation is high, the MPC may raise the base rate to encourage people to save (as savings rates should be higher) and discourage spending (as borrowing will be more expensive) to reduce demand. In turn, this should help to lower prices and inflation.

If the MPC wants to try to strengthen the economy, if inflation is lower than they’d like, for example, it may lower the base rate to encourage people to spend and make saving less attractive (as interest rates are likely to be lower).

UK inflation history

The Consumer Price Index (CPI) began in 1996 as an official figure and, in 2003 , it became the official measure of inflation.

The CPI rose throughout 2021, peaking at 11.1% in October 2022. This was due to a range of factors , including the fallout from the COVID-19 pandemic, supply chain issues, rising energy prices and the war in Ukraine.

Inflation has fallen gradually over the past couple of years, but has been slowly edging slightly higher since the middle of 2024.

What can I do in response to inflation?

To protect yourself against some of the negative effects of inflation, you could adjust your lifestyle and spending habits, review your savings accounts and consider investments.

Adjust your lifestyle

One way to deal with inflation is to find opportunities to reduce your spending. This could include cutting down on non-essential purchases, switching to a cheaper supermarket and buying own-brand products, for example.

You could also see if you can reduce your essential expenditure by moving to a new energy or broadband provider, for example, or by finding a cheaper insurance policy.

By proactively searching for cheaper prices and deals, you can help to minimise the effect of inflation on your finances.

Regularly review your savings

Inflation can eat away at your savings if you’re not earning a decent interest rate on your accounts.

For example, if you have £5,000 in savings at an interest rate of 2%, it would be worth £5,100 at the end of one year. However, if the annual inflation rate is at 3%, your £5,000 (when adjusted for inflation ) would be worth approximately £4,850 – a loss of around £150. Even if you add the £100 interest it earned, the “purchasing power” of your savings would drop by around £50 over one year.

This is why it’s important to regularly review the interest rates on your existing accounts, compare the top savings rates currently available and put your money in an account offering competitive returns.

Ideally, you would have a savings account that pays a significantly higher interest rate than inflation, as this means your money will continue to grow in real terms.

But, even if inflation is high and it’s not possible to get an inflation-beating savings account, it’s still worth putting your money in the most competitive savings accounts to reduce the impact of inflation.

Consider investments

If you have money you don’t need to access for several years or more, it may be worth considering investing.

Over the long-term, investing can be a way to beat inflation and get a return on your money, with gold seen as a particularly popular option during periods of higher inflation.

However, while investing has the potential to offer good returns, it’s important to underline that your investment isn’t guaranteed to grow. Investments can fluctuate in value and past performance doesn’t necessarily mean a certain fund will continue to do well in the future, so there’s always a risk that you could lose money by investing.

There are many options available if you want to invest, each with different pros and cons. For example, you could put more money in a pension, open a stocks and shares ISA or invest into property, for example. You could also use a specialist platform and choose a ready-made investment portfolio or select your own individual funds you want to invest in, for example.

Choose a fixed rate mortgage

If inflation is rising, the Bank of England may raise the base rate which may result in higher mortgage rates.

This means that, if you have a variable rate mortgage, the lender may increase the interest rate on your deal, which in turn will mean you pay more overall.

However, if you lock into a fixed rate mortgage, your interest rate and monthly payments won’t change throughout the term, even if inflation and interest rates rise. This can be an appealing option for those who want stability and don’t want to risk higher payments.

On the other hand, it’s worth bearing in mind that, if you’re locked into a fixed mortgage, you won’t benefit from lower interest rates if they fall during the term (unless you leave your deal, which may come with a fee).