What is inflation?

Published Monday 22 June 2026

Table of contents

• What is inflation?
• How inflation is measured in the UK
• What is the inflation rate?
• Types and causes of inflation
• Why inflation matters to small businesses
• How small businesses can manage inflation
• The Bank of England and inflation targeting
• Manage your business finances with Xero
• FAQs on inflation

Key takeaways

• Inflation is the rate at which the prices of goods and services rise over time, reducing what your money can buy and directly affecting your business costs.
• The UK inflation rate was 2.8% in May 2026, measured by the Consumer Price Index (CPI), with the Bank of England targeting a 2% rate to keep the economy stable.
• Rising costs from inflation can squeeze small business margins, but reviewing your pricing, tracking expenses closely and building flexibility into your budget can help you stay in control.
• Cloud accounting tools like Xero give you real-time visibility over your cash flow and expenses, so you can spot cost increases early and make confident financial decisions.

What is inflation?

Understanding inflation is essential if you run a small business, because it directly affects what you pay for supplies, services and stock.

Inflation is the rate at which the general level of prices for goods and services rises over a period of time. When inflation goes up, each pound you hold buys less than it did before. This loss of purchasing power means the same amount of money stretches less far, whether you're paying for raw materials, energy bills or everyday essentials.

A small amount of inflation is considered normal in a healthy economy. Prices tend to rise gradually over time, and moderate inflation encourages spending and investment rather than hoarding cash. Problems arise when inflation climbs too quickly or stays high for too long, making it harder for businesses to plan ahead and manage their costs.

How inflation is measured in the UK

Knowing how inflation is tracked helps you understand the numbers you see in the news and how they relate to your business costs.

In the UK, the Office for National Statistics (ONS) measures inflation by tracking the prices of around 700 items in a virtual "shopping basket." This basket represents the goods and services that households typically buy, from bread and petrol to streaming subscriptions and gym memberships. The ONS updates the basket each year to reflect changing spending habits.

The 3 main measures of inflation in the UK are:

• Consumer Price Index (CPI): the headline measure used by the government and the Bank of England. It tracks price changes across a broad range of goods and services but doesn't include housing costs like mortgage interest payments.
• Consumer Prices Index including owner occupiers' housing costs (CPIH): a broader measure that adds in housing costs such as mortgage interest and council tax. Many economists consider CPIH a more complete picture of living costs.
• Retail Prices Index (RPI): an older measure still used for some contracts, pensions and index-linked gilts. RPI tends to produce a higher figure than CPI because of differences in how it's calculated.

For most purposes, CPI is the figure that matters most. It's the measure the Bank of England uses to set its inflation target and guide interest rate decisions.

What is the inflation rate?

The inflation rate tells you how fast prices are rising, which is useful when you're deciding whether to adjust your own prices or renegotiate supplier contracts.

The inflation rate is the percentage change in the price level over a set period, usually 12 months. It's calculated by comparing the cost of the ONS shopping basket this year with the cost of the same basket a year ago. If the basket cost £100 last year and £102.80 this year, the annual inflation rate is 2.8%.

As of May 2026, the UK's CPI inflation rate stood at 2.8%. The Bank of England has a target of 2% inflation, which it considers the right level to support steady economic growth without letting prices spiral. When inflation moves significantly above or below this target, the Bank may adjust interest rates to bring it back in line.

Types and causes of inflation

Inflation doesn't have a single cause. Different forces can push prices up, and understanding them helps you anticipate where your costs might rise next.

There are 3 main types of inflation:

• Cost-push inflation happens when the cost of producing goods and services goes up. Rising energy prices, more expensive raw materials or supply chain disruptions force businesses to charge more to cover their costs. For example, when fuel prices surge, delivery and logistics costs rise across the board.
• Demand-pull inflation occurs when demand for goods and services outpaces supply. When consumers and businesses want to buy more than the economy can produce, sellers can raise prices. This often happens during periods of strong economic growth or when government spending increases significantly.
• Built-in inflation, sometimes called the wage-price spiral, develops when workers expect prices to keep rising and push for higher wages. Businesses then pass those higher wage costs on to customers through higher prices, creating a self-reinforcing cycle.

In practice, these types often overlap. A spike in energy costs (cost-push) can trigger higher wage demands (built-in), while strong consumer spending (demand-pull) adds further upward pressure on prices.

Why inflation matters to small businesses

Inflation affects every part of your business, from what you pay your suppliers to what you charge your customers. Understanding both the challenges and potential benefits can help you respond effectively.

The challenges of inflation for small businesses are real and immediate. Higher input costs eat into your profit margins, especially if you can't pass those increases on to customers straight away. Rent, energy bills, insurance premiums and the cost of goods can all climb at the same time, putting pressure on your cash flow.

According to Xero Small Business Insights, UK fuel prices surged by 15% in March 2026, with prolonged high fuel prices potentially triggering a Bank of England rate increase to combat inflation. For businesses that rely on deliveries or travel, this kind of increase hits hard and fast.

As Kate Hayward, UK Managing Director at Xero, noted: "There are challenging months ahead for small businesses. Margins are squeezed by energy and finance costs, and owners are naturally responding with caution."

However, inflation isn't entirely negative for small businesses. If you own property or have fixed-rate debt, the real value of what you owe decreases over time as inflation rises. Moderate inflation can also give you the opportunity to review and adjust your pricing without standing out from competitors, since customers expect some price increases during inflationary periods.

How small businesses can manage inflation

You can't control inflation, but you can take practical steps to protect your business from its worst effects.

Xero Small Business Insights data from 440,000 UK small businesses shows that business owners are already responding to these pressures by adopting a "wait and see" approach on hiring and investment, delaying premises and equipment upgrades, and preferring casual over permanent hires.

While caution makes sense, there are also proactive steps you can take to stay ahead:

• Review your pricing regularly. Don't wait until your margins disappear. Small, frequent price adjustments are easier for customers to absorb than 1 large increase.
• Track your expenses in real time. Use cloud accounting software to monitor where your money is going, so you can spot rising costs early and act before they become a problem.
• Negotiate with suppliers. Lock in prices where you can, explore alternative suppliers and consider buying in bulk for items you use consistently.
• Build a cash buffer. Having a reserve gives you breathing room when costs spike unexpectedly. Even setting aside a small percentage of revenue each month adds up.
• Focus on efficiency. Look for ways to reduce waste, automate repetitive tasks and streamline your operations. Cutting unnecessary costs frees up cash to absorb price increases elsewhere.
• Revisit your budget monthly. A budget that's reviewed once a year won't keep pace with rising costs. Monthly check-ins help you catch problems early and adjust your plans.

The Bank of England and inflation targeting

The Bank of England plays a central role in managing UK inflation, and its decisions on interest rates directly affect your borrowing costs and business planning.

The government sets the Bank of England an inflation target of 2%, measured by CPI. The Bank's Monetary Policy Committee (MPC) meets 8 times a year to decide on the Bank Rate, which is the interest rate that influences what banks charge you for loans and what you earn on savings. As of June 2026, the Bank Rate is 3.75%.

When inflation rises above the 2% target, the Bank typically raises interest rates to cool spending and borrowing. Higher rates make loans and mortgages more expensive, which tends to slow demand and ease price pressures. When inflation falls below target, the Bank may cut rates to encourage spending and investment.

If CPI inflation moves more than 1 percentage point above or below the 2% target, the Governor of the Bank of England must write an open letter to the Chancellor of the Exchequer explaining why. The letter must set out what the Bank plans to do to bring inflation back to target and how long it expects that to take. This accountability mechanism ensures the Bank stays transparent about its approach to price stability.

Manage your business finances with Xero

When prices are rising, keeping a close eye on your finances is more important than ever. Xero's cloud accounting software gives you real-time visibility over your cash flow, expenses and financial performance, so you can spot cost increases quickly and make informed decisions about pricing, spending and financial management. Get one month free.

FAQs on inflation

Here are answers to frequently asked questions about inflation.

What is the current UK inflation rate?

The ONS publishes the latest CPI figure on or around the 15th of each month, covering the previous month's data.

You can check the most recent release on the ONS inflation and price indices page. When the rate sits above the Bank of England's 2% target, borrowing costs for business loans and mortgages tend to stay higher for longer.

What causes inflation to rise?

Global events often trigger inflation spikes that reach UK businesses quickly.

The 2022 energy crisis drove UK inflation to 11.1%, its highest level in over 40 years. More recently, rising fuel costs linked to geopolitical disruption have pushed transport and logistics expenses higher for small businesses across the country.

How does inflation affect small businesses?

The impact depends heavily on your industry and business model.

Service-based businesses often feel the pinch through rising wages and overheads, while product-based businesses face higher material and shipping costs. Checking your profit margins monthly helps you spot when inflation is eating into your bottom line before it becomes a bigger problem.

What is the difference between CPI and RPI?

The distinction matters because different measures are used in different financial contracts.

RPI is commonly used for commercial lease rent reviews, index-linked gilts, and some pension schemes, meaning your costs in these areas may rise faster than headline CPI suggests. When negotiating contracts or reviewing lease terms, check which inflation measure applies so you can budget accurately.

How can small businesses protect themselves from inflation?

There are several practical steps you can take to reduce inflation's impact on your business.

Review your pricing regularly, track your expenses in real time using cloud accounting software, negotiate better terms with suppliers and build a cash reserve for unexpected cost increases. Staying on top of your numbers helps you react quickly when costs change.