Inflation is the rate at which the overall price level of goods and services increases. As prices rise, each pound buys less. If a typical basket that cost £100 last year costs £103 this year, annual inflation is roughly 3%.
Economists and statisticians track inflation with price indexes built from thousands of items. The headline figure is usually given as a year-on-year percentage change in that index.
How inflation is measured in practice
Statistical agencies gather prices for a representative basket of goods and services, weight them by typical household spending, and turn that into an index with a base year set to 100. Changes in the index show how the cost of living shifts over time.
Different indexes exist. Consumer Price Indexes are common. Some countries publish variants that include or exclude housing costs, and some still quote older measures that use different formulas. Central banks may also track a personal consumption or harmonised index that aims to be more comparable across regions. Methods and coverage differ by country and can change, so always check which series you are looking at.
You will often see two versions:
- Headline inflation includes everything in the basket.
- Core inflation strips out volatile items such as food and energy to reveal underlying trends.
Inflation can be reported month on month or year on year. Year on year smooths seasonal patterns by comparing with the same month a year earlier. Month on month is useful for spotting turns but can be noisy.
Simple example: if the index was 120 a year ago and 126 today, year-on-year inflation is ((126 ÷ 120) − 1) × 100% = 5%. If the index rose from 125.0 to 125.5 in a month, the monthly change is 0.4%.
Watch for base effects. If prices jumped a year ago and are stable now, the year-on-year rate may fall sharply even though nothing much changed this month.
Why inflation moves
Broadly, three forces can push inflation around:
- Demand pull when spending runs ahead of an economy’s capacity to produce, pushing prices up. Strong job markets, fiscal support or credit growth can contribute. This often shows up alongside firm readings in GDP.
- Cost push when input costs rise, such as energy, wages, shipping or imported components. A weaker currency can raise the local-currency price of imports, a channel sometimes called exchange-rate pass-through.
- Inflation expectations and wage dynamics. If people expect higher inflation, they may ask for bigger pay rises and firms may adjust prices more quickly, which can keep inflation elevated.
Supply shocks can create short bursts in prices. The policy question is whether those bursts feed into broader, stickier inflation through wages and expectations.
Where you encounter inflation in markets
Inflation touches almost everything priced in money. Here are the main places traders and investors watch it:
- Bonds. Nominal government bond yields tend to rise with higher inflation or higher expected inflation. Inflation-linked bonds adjust principal or coupons with the price index. The gap between nominal yields and inflation-linked yields at the same maturity gives a market-implied breakeven inflation rate.
- Equities. Companies with strong pricing power can sometimes pass on cost increases. Others see margins squeezed if input costs rise faster than selling prices. Valuation multiples can compress when inflation lifts discount rates.
- Currencies. High inflation relative to trading partners can weigh on a currency over time, particularly if it steers the central bank toward easier policy than peers. In the short run, policy surprises often dominate.
- Commodities. Energy and food can both drive and reflect inflation pressures. Some investors treat certain commodities as a hedge against persistent price rises.
- Cash and short-term paper. Rising inflation often brings higher policy rates, which lift yields on money-market instruments. The real value of cash balances still depends on inflation relative to those yields.
Macro traders focus on scheduled inflation releases because they can move yields, currencies and index futures within seconds. Corporate analysts track cost lines, wage settlements and pricing commentary in results calls to judge how inflation is flowing through P&L.
Central banks, targets and policy choices
Most central banks have an inflation target, often framed as a point or a range over the medium term. If inflation runs above target, policymakers can raise interest rates, slow the growth of their balance sheet or signal tighter conditions to cool demand. If inflation runs below target, they can ease policy to support activity and lift price pressures back toward the goal.
Debate about how forceful policy should be is often described with the labels hawks and doves. Hawks worry more about inflation staying high and prefer tighter settings. Doves place more weight on growth and employment and are slower to tighten. The precise framework and tools vary by jurisdiction and can change.
Markets do not just react to current inflation. They react to how inflation data shifts the expected path of policy rates and balance-sheet plans. That is why a small surprise in a core reading can have an outsized impact on yields and risk assets.
Real versus nominal: why inflation matters for returns
Nominal figures are stated in today’s pounds. Real figures adjust for inflation to reflect purchasing power. The real return on an investment is roughly the nominal return minus inflation, with an exact formula of (1 + nominal) divided by (1 + inflation) minus 1.
Example: a savings product yields 4% over a year. If inflation averages 6%, the real return is about −2%. Using the exact formula, (1.04 ÷ 1.06) − 1 is −1.89%.
Wages and pensions are sometimes indexed to an inflation measure, fully or partially, to protect real incomes. Loan agreements and valuation models also use real and nominal rates differently. Real discount rates matter for long-duration assets where small changes compound over many years.
Inflation directly erodes the purchasing power of fiat currency. That is why households care about store-of-value assets and why portfolio construction often blends nominal and real exposures.
Common terms that sit near inflation
- Disinflation is a fall in the inflation rate. Prices are still rising, just more slowly.
- Deflation is a sustained fall in the overall price level. It raises the real burden of debt and can be hard to reverse.
- Stagflation is weak growth alongside high inflation. Policy trade-offs are tougher in this mix.
- Hyperinflation is extremely rapid price increases that destroy confidence in money and contracts.
These labels describe different parts of the cycle and help frame how policy, wages and asset prices might behave.
Reading an inflation print like a trader
When a new report lands, the first pass is the headline year-on-year figure versus forecasts. The second is the core measure. Then come the monthly changes, revisions, and contributions by category. Traders look for persistence across housing, services and wages, not just one-off moves in energy or food. They also consider base effects and seasonal quirks before drawing conclusions about trend.
In short, inflation is both a simple idea and a complex set of measurements. It tells you how fast prices are moving, shapes policy paths, and sets the real yardstick for wages and returns.