After the initial optimism, caused by the first fall of the 12-month rate in April 2013 down to 2.4 per cent, everyone is once again facing unsecure times.
Inflation has risen steadily, having reached 2.7 per cent in May, 2.9 per cent in July, and is expected to peak around 3 per cent over the course of this year.
The Bank of England has the power to control inflation by adjusting the central rate of interest, which determines all other costs of borrowing in the UK. However, the new Governor of the Bank of England is hesitant to go that step, as he seeks stability for the investment market in the long term. In fact, governmental intervention into the economy often does not have the intended effects. For instance, the relatively low cost of borrowing in the UK over recent years, did not trigger the hoped growth.
Either way, inflation or changing interest rates make the financial management in both private and business environments tricky. The following offers some explanation into why.
Consumer Price Inflation Explained
Inflation stands for the increase or decrease in price of common goods and services per month in comparison to the previous year. Inflation is visualised through different measures, such as the Consumer Prices Index (CPI) or Retail Prices Index (RPI). In contrast to the CPI, the RPI also includes housing costs, such as council tax mortgage interest payment.
Comparing the annual inflation of successive months gives an indication of the overall trend. The index is calculated by the Office for National Statistics on a monthly basis, which is tracking the prices of 700 British goods and services across the UK. Indeed, important goods such as petrol get a bigger weighting than, for instance, stamps, and selected items are adapted to changing consumer tastes on a regular basis.
Key effects on businesses
The effects of inflation on consumers are obvious: goods and services become more expensive. Although employers and the government take inflation into consideration, wages, pensions and benefits often do not rise with the same speed than the demonetisation. As a result, consumer demands for products shrink, with some product categories being affected particularly.
The situation is a bit more complex for businesses. In general, businesses need a stable economy, showing only a low and steady inflation. This is because businesses plan their finances, investments and activities well in advance, and rely on estimations of their annual income and expenses. Fluctuating value of the money messes up this financial planning, as future costs and revenue cannot be predicted anymore – a circumstance, which shakes the faith of every decision maker in any company.
According to the specialists at Pulse Accounting, inflation also increases the costs of raw materials or stock, which in turn can lead to higher consumer prices and cash flow problems for the company. In addition, business owners are likely to avoid risky activities such as investments in uncertain times. This in turn impacts negatively on their competitiveness, the overall economic growth and employment numbers.
Here are the effects of inflation on businesses at a glance:
– Cost of raw materials/stock increase, which are transferred onto the consumer
– Decreased demand and less predictable returns on capital discourages investment activities of businesses
– Rising consumer prices decrease the demand for products, which leads to shrinking profits
– Due to higher consumer prices, employees demand for increased wages, which again is transferred into the product prices
– Increased interest rates prevents businesses from borrowing money
– Costs of existing borrowing, however, reduces as the pound values less today than few years ago