Inflation 101: Definition, Measurements, Causes, and Impacts
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. 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 harm 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.
Global inflation rate 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.
What Causes Inflation?
Well, in a way, no one knows for sure, or at least not everyone can agree on the reasons! Numerous theories exist about the cause of inflation. The most notable theories of inflation come from the Keynesian and Monetarist schools of thought.
Founded by British economist John Maynard Keynes, the Keynesian school of thought theorised that inflation is a consequence of economic pressures. These pressures include rising production costs or a rise in aggregate demand (a measurement of total demand for all completed goods and services created in an economy) relative to aggregate supply (a measurement of the total supply of all completed goods and services produced in an economy). Essentially, the school of thought believes that the solution to inflation is government intervention.
Monetarists do not believe that the solution to inflation is government intervention. They believe that an expansion of the money supply causes inflation and that inflation can be controlled by stable growth of the money supply in line with Gross Domestic Product (GDP).
GDP = the value of all finished goods and services made within a country during a specific period.
What Does the Impact of Inflation Look Like?
Let’s say you’ve stashed away $200 into a jar (for emergency cash purposes). Over the next year, you never need to touch the money, which is a good thing, so the jar still has $200 a year later. But the inflation rate has been 2.5% over the year, meaning that the things that you could have bought with that $200 would now cost you $205. Your $200 is now worth less than what you could buy with it. In fact, it will now only buy $195.12 worth of stuff, measured by what you could have bought last year (i.e. in the previous year’s dollars). Ouch!
How do you, as a consumer, counteract the effect of inflation?
The first thing is to hope that you are working in an industry experiencing those higher selling prices. The reason is that they will therefore have the revenue to be able and willing to pay you more!
But as a saver, to put it simply, if your savings are earning a rate of interest the same as the going rate of inflation, then your purchasing power is being maintained. The most common way that people try to hedge against inflation is by putting their money into a savings account that earns interest, hopefully at or higher than the rate of inflation, but unfortunately, that is not always possible.
Savings accounts aren’t currently protecting me well against inflation. What else?
This is where investments come into play. The general rule with investing is the higher the risk, the higher the potential reward. The investments with the highest risk include cryptocurrency, futures and options, and penny stocks. These are certainly not for everyone, mainly if it's with all or a large part of their savings!
On the other hand, low-risk investments, such as Government Bonds, often offer a lower yield than the current inflation rate, so why park your money there, either?
So, what do you do? To answer this, we suggest you learn about the objectives of investments, risk and return and building a diversified portfolio. This will put you in an excellent place to protect and grow your purchasing power over the long run.
Taking the rate of inflation into account isn’t just important for investors. If you’ve got debt, then inflation will impact you, potentially for the better!
👍🏻 If your wages have increased in line with inflation, then you’ve got more money to pay back the original loan sum. This is positive because the original loan sum no longer has the same purchasing power as when borrowed initially. Loans are made in "nominal terms", meaning that it's just a dollar figure that you pay your interest and principal in, without accounting for any change in purchasing power... or your salary!
👎🏻 Inflation that is too high for central bankers' liking (since control of inflation is the mandate for most central banks) is typically responded to with an increase in the base interest rate. When trickled down to consumers, it means hiked interest rates on any loan taken out with a floating interest rate, as well as any deposits you may have. Higher deposit rates can also suck money out of the real, productive economy, which may be either a cure for inflation or a fresh set of problems coming from lower economic growth... or both! A topic to discuss with a friendly expert economist!
When we’re talking about high levels of inflation, then hyperinflation is doomsday. It can be defined as the prices of goods and services increasing by 50% or more (perhaps much, much more) per month. Luckily, this doesn’t occur often, but it can be devastating when it does.
The most famous example is in post-WW1 Germany, where inflation spiralled out of control to the extent that notes had more value in being used to keep the fire burning than as a medium of exchange. In 1923, the price of bread shot up from 250 marks in January to 200,000 million marks by November that year. Workers were often paid twice per day because their morning wage wasn’t worth anything by the time they’d taken lunch. More recently, Zimbabwe's inflation rate in Nov 2008 was 79,600,000,000%, which is basically a doubling of prices every single day (more precisely, a daily inflation rate of 98%, but who's counting?!)
The opposite of inflation, with the general price level of goods and services going down. If you stashed away $200 for a year, and deflation was -2.5%, then your $200 would be able to purchase $205 worth of goods and services a year later.
Unfortunately, not everybody’s a winner. There’s a seller behind those goods and services whose revenue no longer has the same purchasing power. If you believed that something you desired would cost you less next week and even less the week after, would you not be put off purchasing? Poor sellers. Imagine if other people were doing the same with your company and all of its products. One way to combat falling selling prices would be to cut input costs such as wages... maybe even your wages!
In addition, a fall in the general price level means that a borrower’s debt will increase in real value.
A set of circumstances where inflation is high, but economic output remains low (or negative), and unemployment worsens/remains high. This situation creates issues for monetary policymakers, as traditional policies used to reduce inflation may do even more harm by crushing what little remains of economic growth.
High inflation has not been an issue of concern for decades for most of the world, but inflation has increased rapidly so far this year, so it’s important to learn what inflation is, what its causes are and how to live with it.
For many years, the only runaway inflation we have experienced has been in asset prices (which has helped investors increase their wealth massively).
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.
INFLATION 101. COMPLETED. ✅
- Header photo from Unsplash