Inflation figures for 2010 show that the amount by which prices are rising continues to increase. The Consumer Price Index (CPI) rose by 3.7% and the Retail Price Index (RPI), which also includes housing costs, jumped by 4.8%.
On the surface, this sounds like bad news. Aside from higher costs of living, rising inflation puts the Bank of England under pressure to raise interest rates - its usual remedy in such situations. But higher borrowing costs could be a disaster for our fragile economy, as cheap borrowing is arguably the glue holding our house of cards economy together at present.
But before we start worrying, let's take a look at what exactly is causing prices to rise by so much.
What's driving inflation?
The info below shows how much prices rose over the 12 months to 31 December 2010 in the various sectors that comprise CPI, along with their contribution to the overall 3.7% increase.
The left hand list makes it clear that transport costs and food have seen the biggest price rises, followed by alcohol/tobacco and education.
Transport price rises are largely due to soaring fuel costs (which affects most other sectors to some extent) while food prices have been pushed up by lower than expected crop supply due to bad weather. Alcohol and tobacco have been hit by higher taxation while most areas have been affected by last year's VAT rise.
The Government's CPI figure looks at price changes for a typical basket of goods and services, to arrive at the 3.7% figure. The right hand chart shows how much each sector contributes towards this.
How does inflation affect me?
High inflation means prices may rise faster than your earnings or savings/investments, leaving you worse off in 'real terms'. For example, if prices have risen by 4% over the year but your wages only rose by 2%, you can't afford to buy as much as a year ago.
But remember, CPI and RPI figures are simply based on how an average family might spend their money, the extent that rising prices affect you is personal. If you spend most of your money on transport, food, alcohol and smoking then price rises will probably have been more painful versus a teetotal non-smoker who rarely travels and eats very modestly.
And if you have debts, inflation is arguably a good thing as it shrinks them in real terms.
Will inflation keep rising?
The interesting thing here is that prices don't seem to have risen because we're all spending more.
If we were in an era of booming prosperity then I would expect high inflation to continue (greater demand = higher prices), but with our economy still fighting off recession it's quite the opposite.
High inflation has primarily been caused by rising fuel and food prices, which are difficult to predict (and, to a lesser extent, higher taxes). If the climate is favourable for crops this year then food prices will probably fall, whereas oil seems to have benefitted from greater global demand, which may or may not continue shorter term.
I think there's little doubt that growing demand from emerging markets could push up food and fuel prices longer term, but price movements shorter term tend to be volatile.
My gut feeling is that inflation will probably subside later this year, although next month's figures for the year to 31 January 2011 will likely be higher still, reflecting the 1 January VAT rise and even higher fuel costs.
Will interest rates rise?
I would be surprised if the Bank of England raises interest rates in the near future. Yes, it traditionally does in times of high inflation, but raising rates won't really affect fuel or food prices so high inflation could still persist. Worse still, higher interest rates could really stretch a lot of household and business finances, which risks pushing our economy straight back into recession.
Should you take any action?
If you feel the current levels of inflation are more likely an exception than the norm then I wouldn't lose sleep by worrying about it. By all means point to inflation when asking your boss for pay rise, but there's probably no need to restructure your investments.
But if you believe high inflation is here to stay then shifting towards investments that tend to cope better with high inflation might be wise. Which investments are those? I'll write another article covering this shortly.