So the Bank of England Governor has written to the Chancellor. Doesn’t he do that all the time? Not this kind of letter. This is the economic equivalent of having your homework marked, and Mervyn King’s is not up to scratch. He promised to keep inflation at 2 per cent and now has to explain why it is at 3.3 per cent. He will have to write a similar letter every three months until inflation drops back below 3 per cent, making this the start of a long correspondence.

Why should I care what they say to each other? Because inflation affects every part of everyone’s life. Rising inflation means your money won’t stretch as far, your pension won’t be worth as much and it could put your job at risk. Unemployment is already rising.

Where is inflation biting? Food and fuel. A tank of petrol costs about £66, up from £57 a year ago, while the cost of a loaf has risen from 90p to £1.16. But worryingly, core inflation, the cost of goods excluding food and energy, is rising too. Economists say that even if global oil and food prices level off soon, core inflation may keep rising.

So should I ask my boss for more money? The fear is that if everyone asks for a bigger pay packet, companies will increase prices again in order to meet higher wage bills. This vicious circle of rising wages and prices will force inflation even higher.

Why do we need inflation? If prices always fell rather than rose – deflation – people would be reluctant to spend their cash, reasoning that they could buy an item for less money in a month or six months’ time. This drop in spending would be likely to cause the economy to grind to a halt.

Will interest rates rise now? Not necessarily. Each rate cut takes more than a year to have an impact, and the Bank believes that inflation will have started to fall by this time next year.

Why has inflation only risen by 3.3 per cent when my fuel bills are rising so fast? Fuel costs have increased by 19.5 per cent over the past year, but they account for less than 4 per cent of items surveyed for CPI inflation. Smaller increases in items such as furniture and dining out, and falls in the price of clothes and mobile phones, have reduced the overall effect of fuel rises.

Explore Economics

• Pre-Budget Report 2008

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