Q&A: Inflation explained

Inflation is one of the most important issues in economics.

It influences the interest rate we get on our savings and the rate we pay on our mortgages.

Inflation also affects the level of state pensions and benefits, as well as the price of some train tickets.

What is inflation?

Inflation is the rate of increase in prices for goods and services.

There are a number of different measures of inflation in use. The most frequently quoted and most significant ones are the Consumer Prices Index (CPI) and the Retail Prices Index (RPI).

Each looks at the prices of hundreds of things we commonly spend money on, including bread, cinema tickets and pints of beer - and tracks how these prices have changed over time.

The inflation rates are expressed as percentages. If CPI is 3%, this means that on average, the price of products and services we buy is 3% higher than a year earlier.

Or, in other words, we would need to spend 3% more to buy the same things we bought 12 months ago.

RPI includes housing costs such as mortgage interest payments and council tax, whereas CPI does not.

But that only accounts for a small part of the difference between RPI and CPI.

The main difference is caused by the fact that, although they use much of the same data, they calculate the inflation rate using different formulae.

The one CPI uses takes into account that when prices rise, some people will switch to lower priced alternatives. They will swap a higher priced brand of biscuits for a lower one, for example.

This results in a lower CPI reading than RPI in nearly all cases.

Why is it important?

The data from the CPI and RPI rates are used in many ways by the government and businesses, and play an important role in setting economic policy

That's because the Bank of England uses it to set interest rates. If the Bank's Monetary Policy Committee thinks inflation will be above 2% in the next two years or so, it may increase interest rates to try to subdue it.

Conversely if it thinks inflation is likely to be below 2%, it may cut interest rates.

That's why inflation is a crucial factor in determining the rates banks charge for mortgages and the rates they offer on savings accounts.

It also has a direct impact on some people's incomes.

Anything that is described as index-linked rises in line with inflation.

That includes state benefits, pensions and - in part - some train tickets.

Some companies use the level of inflation to set annual pay rises. Recently, however, due to the effects of the recession, many pay settlements have fallen behind price rises.

How is inflation calculated?

Every month the Office for National Statistics (ONS) collects more than 100,000 prices of goods and services from a wide range of retailers across the country - including online retailers.

Prices are updated every month and price collectors visit the same retailers each time in order to monitor identical goods and make sure they are comparing like with like.

All these prices are combined using information on average household spending patterns to produce an overall prices index.

It also takes into account how much we spend on different items.

So items are weighted - i.e. given more importance in the inflation indexes - according to how much we spend on them

We typically spend more on fuel than on postage stamps, for example.

So a large rise in the price of petrol and diesel would affect the overall rate of inflation more, as it has a weight of 4% in the RPI.

Meanwhile a rise in the price of stamps is less likely to affect the overall index, as they have a weighting of 0.1%.

What is quantitative easing?

Since the global financial crisis, both the Bank of England and the Federal Reserve have used the policy of quantitative easing (QE) to try to revive consumer spending and economic growth.

In the UK, the Bank of England began its "asset purchases" in January 2009.

The Bank has so far committed a total of £375bn to QE, while in September the Fed said it would spend a further $40bn (£25bn) per month. This was on top of the $2.3tn the Fed had already put into QE since 2008.

At the Bank's meeting in early February, governor Sir Mervyn King backed more action to boost the amount of QE purchases above £375bn but was outvoted by his colleagues

What is quantitative easing?

 Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates.

Lower interest rates encourage people to spend, not save. But when interest rates can go no lower, a central bank's only option is to pump money into the economy directly. That is quantitative easing (QE).

The way the central bank does this is by buying assets - usually government bonds - using money it has simply created out of thin air.

The institutions selling those bonds (either commercial banks or other financial businesses such as insurance companies) will then have "new" money in their accounts, which then boosts the money supply.

It was tried first by a central bank in Japan to get it out of a period of deflation following its asset bubble collapse in the 1990s

Prior to 2009, QE had never been tried before in the UK

Is this printing money?

These days the Bank of England does not have to literally print money - it is all done electronically

However, economists still argue that QE is the same principle as printing money as it is a deliberate expansion of the central bank's balance sheet and the monetary base

How does it work?

Under QE a central bank purchases government bonds from private sector companies or institutions, typically insurance companies, pension funds and High Street banks.

This increased demand for the government bonds pushes up their value, thereby making them more expensive to buy, and so they become a less attractive investment.

This means that the companies who sold the bonds may use the proceeds to invest in other companies or lend to individuals, rather than buying any more of the bonds

The hope is that with banks, pension funds and insurance firms now more enthusiastic about lending to companies and individuals, the interest rates they charge fall, so more money is spent and the economy is boosted.

Quantitative Easing: Step by step

  First, with the permission of the Treasury, the Bank of England creates lots of money. It does this by just crediting its own bank accounHow do you know if it has worked?A Bank of England report into the effect of its first round of QE (that is, the £200bn worth of purchases made between March and November 2009) suggested that the measure had helped to increase the UK's annual economic output by between 1.5% and 2%, indicating that the effects of the programme had been "economically significant".Yet some analysts have complained that since QE started in the UK in 2008 lending to businesses and individuals has remained sluggish.The simple fact is, no-one knows how bad the UK economy would have been without QE.As BBC economics editor Stephanie Flanders said: "Quantitative easing may well have saved the economy from a credit-led depression. We will never know."Has anyone suffered?One of the effects of QE is to push up the market price of government bonds and consequently to push down the yield they give investors. This has two very important effects.Firstly, QE has being cited as a major reason why UK company pension scheme deficits, calculated monthly by the Pension Protection Fund, have ballooned.That is because the cost of paying pensions from final-salary schemes is calculated on the assumption that all their assets are invested in bonds.As the yield on bonds has dropped, so the stock of assets needed to generate the same level of pension income has gone up.

In May 2012 this collective UK pension scheme deficit reached a record high of £312bn. If this persists then it will have to be paid off by employers, presenting them with a very large bill.

Meanwhile the fall in bond yields has driven down the annual income someone can obtain, by buying an annual pension (an annuity) with their accumulated pension pot.

So, anyone retiring and trying to buy a private pension in the past year or two has lost potential income that they will never get back.

Why are the UK and US's actions different from 1920s Germany and Zimbabwe?

Printing money can be defined as the central bank financing of government debts. This is what happened in both 1920s Germany and Zimbabwe and what the British government will insist it is not doing, although the short-term effect is similar.

According to the Maastricht Treaty, EU member states are not allowed to finance their public deficits by printing money. That is one reason why the Bank of England has been buying government bonds from financial institutions, not directly from the government.

The Bank believes this form of QE is different because it is "printing money" as part of monetary policy - to prevent deflation. It is not printing money to help the government finance its deficit.

Also, unlike Zimbabwe, this is a temporary policy: the Bank expects to sell the government bonds back into the market when the economy recovers.

UK economy: GDP figures explained by ONS

GDP, or gross domestic product, is arguably the most important of all economic statistics. It is a measure of all the activity in the UK economy in a particular period, and is published on a quarterly basis

If the quarterly GDP measure has increased compared with the previous three months, the economy is growing. If the figure is negative, the economy is contracting.

The UK's GDP figures are produced on a rolling monthly basis for each quarter.

Revisions, not mistakes

A first - or preliminary - estimate is produced in the first month after a quarter, a second in month two, and a further revision in the Quarterly National Accounts.

There are later revisions when we do the annual publication of the UK National Accounts - the so-called Blue Book

Revisions to the GDP figures do not usually mean that we have found a mistake - mistakes are actually rare - but rather that we have received new information.

 GDP is compiled from thousands of survey returns completed by UK businesses. The main sources used for the preliminary estimate are ONS surveys of manufacturing and service industries.

Information on sales is collected from 6,000 companies in manufacturing, 25,000 service sector firms, 5,000 retailers and 10,000 companies in the construction sector.

Data are also collected from government departments covering activities such as agriculture, energy, health and education. For the second and third estimates, increasing amounts of data become available from other surveys and administrative sources.

 There is an urge to define the economy as in or out of recession, Mr Grice says

Early 'guess'?

We have now published the preliminary estimate for the first quarter of 2013- the period from January to March.

Coming only 25 days after the end of the quarter, it's the quickest publication of a preliminary estimate in any major economy.

Government and businesses want information fast, so ONS produces its early estimates of GDP based on partial information before all the data that will eventually be available is in.

Does that mean that the preliminary estimate of GDP is really - as some have, indeed, claimed - no more than a 'guess'?

Well, no it doesn't. In fact, the preliminary estimates have proven to be remarkably accurate.

The figure produced in the third month after the end of a quarter - in the Quarterly National Accounts - uses more of the available data. Yet the revision between the first and third monthly estimates is typically only one or two tenths of one per cent

Nor is it true, as some commentators allege, that the first estimate is biased downwards - that they generally underestimate the strength of the economy and will be revised upwards as later estimates emerge.

In fact, the average revision since the start of 2006 between the first figure and the third month has been minus 0.01%. So revisions have generally been very slightly downwards, albeit by a figure so close to zero it makes no difference.

 This means that there would be no benefit in terms of quality, if, as some suggest, we were to delay the production of the preliminary estimate. We'd be losing timeliness but for no gain in quality.

 It's like being able to accurately predict the outcome of an election after only the first 20 or so seats declared.

'Bumpy plateau'

One of the reasons the preliminary GDP estimates, and any later revisions, attract so much attention is the urge to define the economy as in or out of recession: especially when the media is speculating about the possibility of an unprecedented so-called triple-dip recession.

 Recession is often defined as two consecutive quarters of negative growth - or economic contraction. Yet when growth is close to flat, the difference between, say, estimated growth of 0.1% (no recession on the popular convention) and -0.1% (one quarter contributing to a recession on the same convention) is actually within the known statistical margin of error.

 In fact, ONS does not attempt to characterise the economy as in or out of recession. We see no statistical or economic basis for this.

 We recommend looking at the path of the economy over a period of time. Overall, in recent years, the economy appears to have been on a bumpy plateau, with an upward trend but at well below historic growth rates.

 The latest quarterly estimate adds to the story but movements in one quarter, upwards or downwards, need to be seen in the longer context.

The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice