The Big Question: So what is the real rate of inflation, and does it matter that it is going up?

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The Independent Online

Why are we asking this now?

Inflation hit 3 per cent in December, official figures showed yesterday, the fastest pace at which prices have been rising for 11 years.

The figure is an embarrassment for the Bank of England. Since winning independence from the Government in 1997, one of the Bank's most important functions has been to ensure that inflation is never more than 1 percentage point higher or lower than the rate targeted by the Treasury. This target rate is currently 2 per cent so the Bank is on the verge of failing on one of its core tasks.

In its defence, the Bank might point out that the chief reason inflation rose last month was an increase in transport costs, largely as a result of the December increase in fuel duty. However, inflation in this country is now high by international standards. Few of our competitors have yet announced December figures, but in November, when inflation in the UK stood at 2.7 per cent, it was just 2 per cent in the US. The eurozone average for November was just 1.9 per cent.

What happens if the Bank of England misses its target?

Mervyn King, the Governor of the Bank, is legally required to write an open letter to Gordon Brown, Chancellor of the Exchequer, explaining what it plans to do to rectify the situation. Although the 2 per cent target rate is in one sense an arbitrary yardstick, moving more than 1 percentage point away from it would still represent a very significant economic development.

The Bank has not missed the target range since independence in 1997 and Gordon Brown's decision then to move to this model of inflation control has been widely praised. If an independent Bank of England were to fail on inflation targeting, the Government's economic policy would be undermined.

Why does rising inflation matter?

Inflation is a measure of how quickly prices for goods and services are rising. Without price stability, it is very difficult for any economy to grow at a sustainable pace and thus to provide stable levels of employment and income for the population. Rising prices, for example, reduce the value of money - each pound in your pocket buys less of the same things. However, the Bank of England's job is not to deliver as low an inflation rate as possible. Undershooting the current 2 per cent target rate by more than 1 percentage point would be just as serious as inflation above 3 per cent. Modest inflation is a consequence of sustainable economic growth.

Are prices really only rising at 3%?

It depends which prices you mean. Since 2003, the Government has reported inflation using a statistical measure known as the consumer price index (CPI). One advantage of this measure is that it is very similar to the way other countries report inflation, which makes meaningful international comparisons simpler.

The CPI is calculated according to the prices of a basket of goods and services that the Office of National Statistics (ONS) judges to be representative of the way in which the typical Briton spends his or her cash. But there are different measures of inflation that are based on different baskets and thus give different results.

For example, the retail price index (RPI), the measure used until the introduction of the CPI, includes spending on council tax and mortgage interest payments. It is currently running at a significantly higher 4.4 per cent. This number is important because it is commonly used by trades unions and employers in wage negotiations.

Then there's RPIX, which is very similar to the RPI but excludes mortgage interest payments. In practice, all inflation measures are averages; the individuals who make up the averages may be having very different experiences. This is one reason why the ONS has this week launched an interactive calculator on its website, which allows users to work out their own personal rate of inflation, depending on how they actually spend their cash.

This calculator throws up some interesting results. It shows, for example, that for pensioners, who typically spend a larger proportion of their income on fuel bills, inflation may be currently running into double figures because gas and electricity prices have soared over the past 18 months. Homeowners also face above-average inflation because mortgage costs have risen sharply over the past six months.

On the other hand, prices of clothing, household goods and communications have been rising more slowly, or even falling in recent times. If you spend a great deal of your income on these items, your actual rate of inflation may be well below 3 per cent.

Is inflation likely to keep rising?

Economists are divided on the short-term outlook for inflation. The good news is that oil prices are set to continue falling, which should mean lower petrol prices. Energy bills are also finally coming down. In addition, the Bank of England's decision to raise interest rates last week may lead to lower consumer spending, which would be anti-inflationary. On the downside, if the current round of wage negotiations produces higher-than-expected pay rises, that could undo the effect of the interest rate rise. And even a small shock - a rise in food prices due to a few weeks of poor weather - might be enough to push inflation above 3 per cent.

What does this mean for my finances?

The Bank of England's key tool for managing inflation is interest rates. Last week's rise from 5 to 5.25 per cent was unexpected but the Bank had early access to yesterday's inflation data and it now seems clear this was a crucial factor in the increase.

Leading mortgage providers have already said they will pass the interest rate rise on to homeowners, adding around £25 a month to the cost of the average loan. But unless inflation starts coming down quickly, the Bank of England may be forced to raise rates again - possibly as early as in the spring.

Anyone with a mortgage therefore has good reason to fear higher inflation, because higher interest rates are likely to follow. But even if you're not a homeowner, rising prices are still bad news. Unless your earnings are keeping pace with inflation, for example, you'll be worse off in real terms.

The worst-case scenario is that the UK faces several interest rate rises over a short space of time, leading to a housing market collapse and a sharp economic slowdown. As well as proving disastrous for millions of people, such a scenario might also end certain political careers. It would represent a return to the boom and bust economy Mr Brown has repeatedly claimed to have jettisoned for good.

Is inflation rising dangerously quickly?

Yes...

* The Bank of England is close to being forced formally to explain why it has allowed inflation to move above 3 per cent

* Interest rate rises made to restrain inflation are already hitting homeowners hard and may continue

* For pensioners and homeowners inflation is much higher than official measures show

No...

* The Bank of England has already taken action to bring inflation back down.

* Falling oil prices and home energy bills will result in lower inflation in the coming months.

* Both inflation and interest rates remain very low by historical standards

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