Inflation is the rate at which prices rise over time — and the rate at which money loses its purchasing power. A pound today buys less than a pound did ten years ago. Understanding how inflation is measured, what drives it, and how to account for it in financial planning is one of the most practically useful things you can know about economics.
How Inflation Is Measured
Governments measure inflation using a price index — a basket of goods and services representing typical consumer spending. The price of this basket is tracked over time.
UK: Consumer Prices Index (CPI) The Office for National Statistics (ONS) surveys prices of around 700 goods and services monthly, weighted by how much households typically spend on each. Housing costs are excluded from CPI but included in CPIH (CPI including owner-occupiers' housing).
UK: Retail Prices Index (RPI) An older measure, higher than CPI because it uses a different formula and includes mortgage interest payments. Used for index-linked gilts, rail fare increases, and student loan interest (Plan 1).
US: Consumer Price Index (CPI-U) Produced by the Bureau of Labor Statistics. Categories include food, housing, apparel, transportation, medical care, recreation, and education.
The Inflation Rate Formula
Inflation rate = ((CPI this year − CPI last year) / CPI last year) × 100
Example: CPI was 128.4 last year and is 131.7 this year.
Inflation = ((131.7 − 128.4) / 128.4) × 100 = (3.3 / 128.4) × 100 = 2.57%
What Inflation Does to Money
A simple but important calculation: how much will £X buy in Y years if inflation averages Z%?
Future value (in today's money) = Current value / (1 + inflation rate)^years
Example: You have £50,000 in a savings account paying 2% interest. Inflation is 3%. In 10 years:
Nominal value (what the account shows): £50,000 × (1.02)^10 = £60,950
Real value (purchasing power in today's money): £60,950 / (1.03)^10 = £45,340
Despite the account growing, you've actually lost purchasing power — your money buys less than it did 10 years ago. This is the silent cost of holding cash when inflation outpaces interest rates.
The Rule of 70
A quick mental shortcut: divide 70 by the inflation rate to estimate how many years it takes for prices to double.
At 3.5% inflation: 70 / 3.5 = 20 years for prices to double.
At 7% inflation: 70 / 7 = 10 years for prices to double.
At 2% inflation: 70 / 2 = 35 years for prices to double.
Real vs Nominal Returns
Nominal return: The percentage gain on paper, before accounting for inflation.
Real return: What you actually gained in purchasing power.
Real return ≈ Nominal return − Inflation rate
More precisely (Fisher equation):
(1 + real) = (1 + nominal) / (1 + inflation)
Example: Investment returns 8% nominal. Inflation is 3%.
Approximate real return: 8% − 3% = 5%
Exact real return: (1.08 / 1.03) − 1 = 4.85%
All long-term investment goals should be expressed in real terms — the nominal figure is misleading because it doesn't account for what the money will actually buy.
Types of Inflation
Demand-pull inflation: Too much money chasing too few goods. Occurs during economic booms, stimulus periods, or supply shocks. COVID-era inflation had significant demand-pull elements from government spending.
Cost-push inflation: Rising production costs (energy, wages, raw materials) passed on to consumers. The 2021–2023 energy price spike contributed to cost-push inflation across Europe.
Built-in (wage-price) inflation: Workers demand higher wages to keep up with rising prices; businesses raise prices to cover higher wages. Can become self-reinforcing (a wage-price spiral).
Monetary inflation: Caused by excessive money supply growth. The quantity theory of money: more money chasing the same goods = higher prices.
How Central Banks Control Inflation
The Bank of England and US Federal Reserve primarily use interest rates to manage inflation.
Raising rates: Makes borrowing more expensive, reducing consumer spending and business investment. Slows the economy and cools inflation. Also makes saving more attractive, drawing money out of circulation.
Lowering rates: Stimulates borrowing and spending, useful when inflation is too low or recession threatens.
The UK's inflation target is 2% (CPI). The Fed targets 2% (PCE). Sustained deviation from target triggers policy responses.
Protecting Yourself from Inflation
Invest rather than hold cash: Equities have historically returned 5–7% real (after inflation) over long periods. Cash in low-interest accounts loses real value steadily.
Index-linked investments: UK Index-Linked Gilts and US TIPS (Treasury Inflation-Protected Securities) adjust principal and interest payments with inflation.
Property: Historically tracks or beats inflation over long periods, though with high transaction costs and illiquidity.
Pension contributions: Most workplace pensions are invested in growth assets. Pension income in retirement may also increase with inflation — check whether your scheme offers index-linking.
Avoid long-term fixed-rate lending to others: A 30-year fixed mortgage is great for the borrower during high inflation — they repay with cheaper future money. The lender receives less real value over time.
Use our Inflation Calculator to see how purchasing power changes over time and what a historical amount of money is worth in today's terms.