Student special:  inflation explained

A recent explanation by a Treasury economist detailed the positive impacts of lower inflation on the UK economy, businesses, and personal finances.

But first let's consider how inflation is measured and what inflation tells us

Inflation measures the change in prices of goods and services in the economy, and a drop in inflation indicates that prices are rising more slowly. This scenario can enhance the affordability of living costs by increasing an individual's purchasing power. It will allow them to buy more with their money, save more, and enjoy a better quality of life.
Lower inflation supports the economy by maintaining the purchasing power of money. When prices rise slowly, people can plan their budgets more effectively, which helps them ensure proper spending and investment. This is a major factor in fuelling economic growth. For businesses, a stable and predictable environment resulting from lower inflation allows for growth, job creation, and the ability to research and develop new products and services.

And, let’s consider how low inflation benefits companies wanting to export or trade globally

A stable economy with low inflation enhances the UK's competitiveness in the global market. The country will be better placed to attract foreign investment and secure better trade deals. These factors can collectively strengthen the overall economy. Lower inflation has tangible benefits for businesses. It means that the prices of materials used in producing goods and services are not rising steeply, which relieves the pressure on businesses to pass on price increases to their customers.
For instance, a coffee shop would face less frequent hikes in coffee beans, paper cups, or energy costs, allowing it to maintain stable customer prices. This stability empowers businesses to make informed decisions about their future operations. In contrast, high and volatile inflation makes it difficult for businesses to plan for long-term investments and expenditures.

Why mortgage rates are linked to inflation and the Bank of England Base rate

Lower inflation also impacts the mortgage market. Inflation indirectly influences mortgage rates through financial market expectations regarding the Bank of England’s base interest rate. The base interest rate, or Bank Rate, is a key tool the Bank of England uses to control inflation. Mortgage rates are generally priced based on what financial markets anticipate future interest rates. If markets expect higher inflation, they predict an increase in the Bank Rate to cool the economy and bring inflation back to target, which is reflected in higher mortgage rates.
On the flip side, if inflation falls more rapidly than anticipated, it can lead to a decrease in market expectations for the base interest rate, potentially resulting in lower mortgage rates. This situation could make borrowing more affordable for individuals, alleviating the financial burden on homeowners and prospective buyers.

Why a low inflation economy is the Holy Grail

The Treasury economist points out that lower inflation provides various benefits, from enhancing economic stability and business growth to making everyday living costs and borrowing more manageable for individuals.