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The Bank of England's 2% Inflation Target
Helping you understand inflation, it's importance to the UK economy and what it could mean for your business.
What is inflation?
Inflation measures how much the price of a representative basket of goods and services changes over time. The ONS collects over 180k prices every month and their contribution to overall inflation depends on its weight within the basket i.e. what proportion of household spending is spent on that good or service. Those weights change annually which enables the products to change, for example air fryers, rice cakes and VR headsets have all been added in recent years.
The headline CPI rate shows the year-on-year change in the aggregate basket price.
The Bank of England's 2% inflation mandate
The overarching goal of the BoE is to maintain price stability which is judged to be achieved when the inflation rate is sustained at 2% in the medium term. That is similar to other developed central banks. However, more unusually in the UK, it’s the Treasury which decides the BoE’s remit, including the inflation target, and it usually re-confirms that remit every year. In November 2024, Chancellor Reeves said the 2% inflation target reflects the “primacy of price stability”.
The UK’s inflation targeting regime was born following its departure from the European exchange rate mechanism in 1992, when the UK needed a ‘nominal anchor’ for the price level. Initially the Chancellor imposed an inflation targeting range of 1.0%-4.0% which later became a 2.5% target based upon RPIX - an alternative measure of inflation.
It wasn’t until 2003 when inflation targeting as we know it today was born. The CPI inflation rate became recognised as the better measure of price changes, however, because of difference in the methodologies, CPI historically ran lower than RPI. So, in December 2003 the Chancellor set a CPI inflation target rate at 2%.
A target of inflation at 2% was judged to be broadly aligned with inflation preferences in the UK. It’s important to have a degree of inflation within an economy, it not only signals growth, employment and rising wages, but without it, consumers may put off spending into the future in the expectation of lower prices and reduce demand now. But as events of the past have shown if inflation is too high or is volatile, it’s hard for households to plan spending and difficult for businesses to set prices and wages.
While pinpointing an optimal rate of inflation is difficult, delivering a low and stable rate of inflation should, and in principle, help keep future price changes predictable, while building trust in policies set by the Bank of England.
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