Inflation rockets to 4%

Inflation now stands at double the Bank of England's target.

The Office for National Statistics has confirmed that the cost of living has jumped yet again, with the Consumer Price Index (CPI) annual inflation rate rising to 4% - double the Bank of England’s target.

The figure represents a rise from 3.7% in December, with CPI now at its highest level since November 2008.

A second measure of inflation, the Retail Prices Index (which includes things like mortgage costs) also rose in January, to 5.1% from 4.8% in December.

What it means

Inflation, very simply, tells us how the general cost of living is changing.

The Office of National Statistics uses a basket of goods to calculate how prices have changed over the month. And with inflation consistently on the rise over the last couple of years, it tells us that everyday life is getting more expensive.

The losers

All sorts of different people suffer when inflation is rising. All of us on stable salaries are losers when inflation jumps – while the cost of living goes up, our salaries do not. As a result, your money does not stretch as far as it did previously.

This puts pressure on employers to increase pay, meaning they face higher costs, which can force them to put up prices... and so the inflationary spiral continues.

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Pensioners have suffered the most as a result of inflation in recent times. That’s because the inflation they feel has been substantially higher than the official figure, as things they tend to spend more than the rest of us on (utilities for example) have seen the largest rises, while areas where prices have fallen significantly, like mortgages, have been of less relevance to older people, who will likely have already finished paying for their home.

This inaccuracy between the official rate of inflation, and the actual rate, makes financial planning for those in or nearing retirement far more difficult.

For more on how older people are whacked by inflation, have a read of Scary truth about our substandard pensions.

The final big set of losers with rising inflation is the nation’s savers. In order to beat inflation, a basic rate taxpayer will now need to find an account paying 5%, while higher rate taxpayers need to save at a rate of 6.67%.

Needless to say, there aren’t too many accounts offering deals like that at the moment. Indeed, according to Moneyfacts, the number of accounts that beat inflation for basic rate taxpayers has plummeted from 118 in September to just 23 today, of which 21 are ISAs. But don't despair - read the new savings account that beats inflation for tips on where to put your money.

And with many pensions relying on their savings income, it's a double whammy for the UK's older population.

Why it’s rising

So, why is inflation on the rise to such a degree? According to the Office of National Statistics, there are a number of factors behind inflation heading north.

Transport

Firstly, there are transport costs. There is the price of oil, which has led to petrol prices reaching an average of £1.27 per litre, a new record high. But you also have to take into account the rise in fuel duty, while the costs of purchasing a new car have jumped 2.4% from December to January. Indeed, even the price of second-hand cars has increased by 2%.

Booze and fags

The cost of alcoholic beverages and tobacco rose by a record 4.6% between December and January, with whisky and vodka prices in particular rising sharply. And tobacco products jumped 2.9% too.

Restaurants and hotels

Within this category, prices rose by 1.3% between December and January, another record monthly increase. Once again, the rising prices of alcoholic beverages played a big part in this.

Sterling

Add to all of this the fact that the value of Sterling has been pretty poor for quite a while now. As the pound gets weaker, it doesn't stretch so far, further pushing prices up.

The role of VAT

Now, many people, including the Office of National Statistics itself, is pointing the finger at this year’s rise in VAT to a rate of 20%.

And clearly, it does not help. After all, there was a 2.5 percentage point rise in VAT in January last year too, and CPI inflation at that point jumped to 3.5%.

However, there is an argument that VAT on its own will not boost inflation. Inflation is an annual measure of the rise in prices, and as there was a 2.5 point rise last year too, it simply means that inflation will not fall compared to last year, rather than that it increase further.

What happens next?

The Bank of England is tasked with keeping inflation under control, and operates with a target of 2% for CPI. However, inflation has been at least 1% ahead of this target for more than a year, putting pressure on the Bank of England to act.

Mervyn King, the governor of the Bank of England, has to write to the Treasury when inflation reaches a level 1% above target, and then every three months afterwards, to explain why inflation is rising and what the Bank of England plans to do about it. Needless to say, Mr King has been writing a lot of letters of late.

The most obvious course of action for the Bank of England to take would be to increase bank base rate, a traditional measure to dampen inflation. However, that appears unlikely, for the time being anyway. In his letter, King highlights that while inflation is likely to rise to nearly 5% in the coming months, that will be largely due to rising commodity and energy prices, and that such factors will wane in time, bringing inflation back under control.

It’s worth noting however that King acknowledges there are differences within the Monetary Policy Committee over what to do next. As a result, imminent rises in base rate cannot be completely ruled out.

Can I do anything?

In truth, there’s not a vast amount that you can do about inflation. If you have cash in savings, it’s well worth spending a bit of extra time to ensure you find an account that will beat inflation, limited though your choice may be.

And it’s worth looking at ways to cut your cost of living. That could mean downgrading from your current supermarket of choice, switching your energy provider or broadband deal, or just using your car as little as possible.

Sadly, inflation is not going anywhere for a while.

More: The new savings account that beats inflation | Seven ways to maximise your savings in 2011