What Is Inflation and How Do We Measure It?

Inflation is the pest to your purchasing power and can eat away at it if you don't take proper precautions

• Inflation is a rise in the general price level of goods and services in an economy. We haven't seen much high inflation in recent decades, but we are now. Still, when it appears, the effects can be devastating.
• Inflation is most commonly measured by the increase in the Consumer Price Index (CPI). But it would be better to think of it as a decrease in the amount of stuff that you can buy with your money. 
• Savings accounts may not protect you well against inflation, so this is where investments come into play, such as shares, certain bonds like TIPS, precious metals, commodities and various real estate investments including REITs.

Inflation can be defined as the rise in the general price level of goods and services in an economy.

High levels of inflation can have severe consequences, but actually with any amount of inflation, your money’s purchasing power decreases, meaning it’s worth less. Basically, you can buy less stuff for the same amount of money as time goes on. On a macro level, it has been proven that excessive inflation levels are harmful to long-run economic growth. (Generally, periods of sustained low inflation are seen as desirable for sustained economic growth).

What Does ‘On a Macro Level’ Mean?

The ‘macro’ environment describes a set of circumstances that occur in an economy collectively, as opposed to one element of it, e.g. the housing market. Aside from inflation, gross domestic product (GDP), employment levels, spending, fiscal and monetary policy are all studied from a macro point of view. 

How Do We Measure Inflation?

The most common measure of inflation is the annual percentage change in the Consumer Price Index (CPI). Rather than measuring the costs of all goods and services in the economy, the CPI measures the costs of a set basket of commonly consumed goods and services. This particular basket focuses on consumer prices, but other baskets are used, e.g. the producer price index, the wage price index, "core" consumer prices, and CPI Transportation. 

In Singapore, the CPI consists of 6800 goods and services from 4200 outlets, with housing, food and transportation as the largest components. 

Inflation in Singapore over the past 10 years:

Global inflation 1981 to 2023:

How Is the CPI Compiled?

CPI measures the change in the price of certain goods and services over a period, indicating what consumers are willing to spend on products compared to before. 

The prices of goods and services can be measured monthly, quarterly, half annually, annually, or as and when they change. For volatile goods and services, prices are often measured weekly. However, monthly time frames are common.

The CPI is calculated individually for different sectors and weighted based on their relative importance to calculate the final CPI value. For example, a price increase in a heavily consumed good or service e.g. petrol would have a larger impact on a household than an increase in the price of Nike trainers. The average consumption patterns of the population drive the sectors of a country's CPI basket.

In Singapore:

• The CPI is computed by the Department of Statistics (DOS) every month

• The CPI weights are derived from the Household Expenditure Survey

• Every five years, the DOS update which goods and services will make up the CPI, plus their respective weights

Examples of what’s not included:

• Loan repayments
• Income taxes
• Purchase of houses, shares and other financial assets

The Monetary Authority of Singapore (MAS) prefers to focus on a slightly different measure of inflation, called core inflation. This measure of inflation differs from CPI in that it does not count accommodation costs (i.e. rent) or private transport costs (i.e. car expenses). The reasoning is that most Singaporeans own their property and take public transport.

Conclusion

Inflation can wreck the purchasing power of things like your savings and potentially lead to a hike in the interest rate you’re paying back on a loan. 

The best way to protect yourself from the negative effects of inflation is to invest sensibly in a diversified portfolio of assets.

WHAT IS INFLATION? COMPLETED. ✅

Sources:

1. http://www.worldgovernmentbonds.com/bond-historical-data/singapore/10-years/
2. https://www.singstat.gov.sg/modules/infographics/consumer-price-index
3. https://www.vox.com/2014/7/24/18080392/inflation-definition-and-explanation
4. Header photo from Unsplash