2.5.1 - Economic Influences

Inflation and CPI

Inflation matters because businesses buy inputs and sell outputs in an economy where prices are constantly changing. If the general price level rises, firms may face higher wage demands, more expensive raw materials and bigger transport or energy bills. If they cannot pass those costs on to customers, profit margins are squeezed.

The important distinction is that the CPI is the measure, while the rate of inflation is the percentage increase shown by that measure over time. A higher CPI level means the average price level has risen; it does not by itself mean inflation has accelerated. For example, prices can keep rising while the annual inflation rate falls. Faster inflation requires a larger percentage increase over comparable periods.

An index number expresses a value relative to a stated base period, set at 100. Values are comparable only when they use the same measure and base. In this original price-index example:

The Year 2 index means average prices are 14.4% above the base-period level. It does not mean annual inflation is 14.4%. The annual increase from March, Year 1 to March, Year 2 is $\frac{114.4-110.0}{110.0}\times100=4.0\%$; the rise of 4.4 index points is not a 4.4% rise. A firm's own input prices can change differently from this economy-wide average, so it should also examine its actual suppliers and contracts. The distinction between index levels and comparable-period percentage changes follows the ONS consumer price guidance.

For businesses, higher inflation can create a double pressure. First, costs rise because suppliers and workers may charge more. Second, some customers lose real purchasing power, so they cut back on non-essential spending. Because costs may rise before sales revenue does, inflation can damage profitability and make planning harder. A business agreeing long-term contracts at fixed prices is especially exposed, because its revenue may stay fixed while its costs climb. If UK inflation is higher than inflation in competitor countries, UK firms may also become less price-competitive in export markets. By contrast, lower or more stable inflation makes pricing, wage planning and investment decisions easier.

Exchange rates

An exchange rate changes the relative price of imports and exports, so it matters most to businesses that buy from overseas, sell overseas, or compete against foreign producers in the UK market.

An appreciation means the pound rises in value. A depreciation means the pound falls in value. That distinction is high yield because the effect reverses depending on whether the business is mainly an importer or an exporter.

Because of this, the same exchange-rate movement can create winners and losers at the same time. A manufacturer exporting from the UK may benefit from a depreciation because overseas buyers can buy its goods more cheaply. However, a retailer importing finished products may see its costs jump, which then leads to higher prices or lower margins.

Interest rates

Interest rates affect businesses through both finance costs and customer demand. That is why a change in interest rates can quickly alter sales, profit and investment plans.