What is inflation?

If a coffee costs £3 today and £3.15 next year, that 5% rise is inflation at work. Multiply that across every good and service in an economy and you have one of the forces that drives central bank policy, bond yields, share valuations, and currencies.

How inflation is measured

Inflation is tracked by pricing a representative "basket" of goods and services over time. Two measures dominate:

• CPI (Consumer Price Index) — tracks a fixed basket representative of household spending. It’s used for inflation-linked bonds, benefit adjustments, and public reporting. (The UK’s version, CPIH, also includes owner-occupied housing costs.)
• PCE (Personal Consumption Expenditure) — the US Federal Reserve’s preferred measure. It adjusts the basket over time to reflect how people actually shift their spending, so it tends to run slightly below CPI.

You’ll also hear about core inflation, which strips out food and energy. Those two are volatile and driven by supply shocks, so removing them gives a cleaner read on the underlying, demand-driven price trend — which is what central banks focus on.

What causes inflation

Broadly, inflation comes from three places:

• Demand-pull — too much money chasing too few goods. When an economy overheats, with low unemployment and strong spending, firms can raise prices.
• Cost-push — rising input costs passed on to customers. Think the oil shocks of the 1970s, or the supply-chain disruption of 2021–22. This kind is harder for central banks to tackle without risking a recession.
• Expectations — the self-fulfilling kind. If workers and firms expect higher prices, they ask for higher wages and raise prices pre-emptively, which makes the inflation real. Breaking this cycle is why central-bank credibility matters so much.

Inflation and asset prices

Inflation doesn’t hit every investment the same way:

• Bonds tend to suffer. A fixed coupon buys less in real terms, and rising inflation usually pushes interest rates up, which drives bond prices down.
• Equities are mixed. Moderate inflation is often fine — companies pass cost increases on to customers. But high inflation usually means higher rates, which tends to compress valuation multiples like the P/E ratio.
• Real assets — property, commodities, infrastructure — often act as a hedge, since their values and revenues tend to rise with prices. Gold is the traditional (if imperfect) inflation hedge.
• Inflation-linked bonds (like TIPS or index-linked gilts) have their principal tied to CPI, so they aim to protect your real return whatever inflation does.