What is inflation?
Simply put, inflation is a general rise in prices across a national, or global, economy over a period of time. Remember when you could get that childhood chocolate bar for 5 cents and it’s now 25 cents? That’s inflation at play.
Inflation is measured as the rate of change of prices, and is typically calculated as the percentage change in a price index over time. This can be seen as a decrease in the purchasing power of money, as the same amount of money will be able to buy fewer goods and services in the future due to the increase in prices.
Whilst inflation might feel daunting, it is actually a very normal and necessary part of a healthy economy, as it allows for growth and flexibility. However, if inflation gets too high, it can be detrimental to the economy and lead to economic problems, both for societies but for individuals too (but more on that later).
Let’s say a loaf of bread costs $1, but the economy experiences inflation of 10%. That means that the very same loaf of bread is going to cost $1.10. But when inflation happens, the majority of goods are impacted. So you can expect that your carton of milk will jump from 80 cents to 88 cents. If you added 10% on the amount of everything you purchase, think how much you’re spending overall. You’re essentially increasing your expenditure by 10% – and that’s a lot when you come to think of it.
That’s why when inflation occurs, the purchasing power of money decreases, meaning that the same amount of money will be able to buy fewer goods and services in the future. This is because as prices rise, the same amount of money is worth less in terms of its ability to purchase goods and services. So, if your income doesn't increase by at least the same rate of inflation, you will not be able to buy more loafs or bread or cartons of milk.
What is the difference between inflation and hyperinflation?
Hyperinflation is a very high and typically accelerating rate of inflation, typically measuring more than 50% per month. It is a situation where the prices of goods and services increase rapidly and significantly, leading to a plummet in the value of money. This can happen when a country experiences a severe economic crisis, such as a war or a financial crisis, and the government responds by printing a large amount of money to try to stimulate the economy. However, this can lead to too much money being in circulation, which drives up prices and leads to hyperinflation. This can have severe negative effects on the economy, such as people losing faith in the currency and a decline in the standard of living.
Some countries have suffered from hyperinflation over time, such as in Germany after World War II, when people needed to take wheelbarrows full of money just to buy a loaf of bread. The good news is we’re not experiencing hyperinflation, so rest assured there.
Back to inflation: How do countries measure it?
Each country has a slightly different way of measuring inflation, in the UK the RPI and the CPI are used, whilst the US uses a measurement called the PCE, and the EU uses an overarching ‘Harmonised’ HICP measurement.
Whilst we don’t want to be taking wheelbarrows of cash to the supermarket, most developed economies target some level of inflation, as it is generally seen as a good thing. Within the EU and the US, this is usually a target of up to 2% per year.
Over the last 10 years, there has been very low inflation in the EU and the US, with only China and some other East Asian nations achieving the targeted rates of inflation. However, as recent events have shown, the world is experiencing inflation levels of around 10%, caused by world events, supply chain issues and recessionary fears.
What causes inflation?
There are several factors that can cause inflation. One of the most common causes is an increase in the money supply. When there is more money in circulation, people are able to spend more on goods and services, which can drive up prices. This can happen when a central bank, such as the Federal Reserve in the United States, increases the money supply by printing more money or lowering interest rates.
Another common cause of inflation is an increase in demand for goods and services. When more people want to buy goods and services, businesses may raise their prices to take advantage of the higher demand. This can also happen when the economy is growing quickly, as more people are working and earning money, which can lead to increased demand for goods and services. This is known as cost-pull inflation.
Inflation can also be caused by other factors, such as an increase in the cost of production, such as when the cost of raw materials or labor increases. It can also be caused by external factors, such as when a country experiences a natural disaster or a global economic crisis.
"The best way to protect yourself from inflation? Investing your money"
What does inflation have to do with investing?
Inflation can have a significant impact on investing. When inflation is high, the purchasing power of money decreases, which means that the same amount of money will be able to buy fewer goods and services in the future. This can make it difficult for investors to make money by saving their money in a bank account or other low-risk investments, as the value of their money will be eroded over time.
Savings vs investing
Inflation is running rampant, meaning that your money is depleting in value in real terms by sitting quietly in a bank account. Let's say inflation averages 3% over the next 5 years. That means what costs you $1,000 today would cost you $1,159.27 in five years time.
If you put $1,000 in a savings account today paying 0.5% interest, you’ll only earn $25.25 interest over the same period. So you'd effectively lose $134.02.
So, what’s the steps to beat inflation? Investing.
Investing in stocks and shares has yielded 7 to 10% per year on average over time, meaning you can protect yourself against higher rates of inflation. Because let’s say inflation is up 5% in a year, but you make a return of 8% on your investments, then you’re going to come out on top having invested your money in stocks and shares. But don’t be fooled; that growth will still face the same ‘real’ loss as with cash in the bank.
Invest your money to beat inflation
The good news is that investing provides a channel for you to beat inflation, and avoid the trap of depleting savings going cold in your bank account. By investing in a range of different classes such as funds, shares, bonds and other assets, you’re giving your money the fuel it needs to grow over time. Investing in these types of assets can help investors preserve the purchasing power of their money and maintain your standard of living over time.
Want to see how much your money could grow over time? Play around with our investment calculator.
Asset classes and inflation
It’s important for investors to carefully consider the potential impact of inflation on their investments and to make investment decisions accordingly. This can help them protect their wealth and achieve their financial goals over the long term. Despite markets being unpredictable during inflation, history and economics offer some rules of thumb.
- Stocks: Stocks and shares have the potential to outpace inflation, but it’s not equal across the board. Some stocks will perform better than others during inflation.
- Bonds: Because interest rates go up, bond prices actually go down. This is good for someone looking to buy bonds during inflation, but not so good for the bond owner who’s looking to sell it!
- Commodities: Commodity prices tend to rise alongside the prices of finished products made from those commodities in inflationary environments, meaning commodity prices could soar.
- Real estate: Real estate is a popular choice because you can accumulate increased rental income and benefit from the surge in monthly payments, for example.
Inflation and currency conversion
Inflation can also affect currency competitiveness. To dive deeper into this, let’s say you’re buying stocks and shares from Japan, in Japanese Yen (JPY) and you are based in France, purchasing your investments in Euros (EUR). If the JPY experiences high levels of inflation, then it becomes more expensive to buy with EUR. Over time, this erodes competitiveness with the Euro and other global currencies, resulting in your investments actually losing money despite seeing growth. Are you a bit mind boggled yet?!
The bottom line
In a nutshell, inflation is one to watch when you’re holding cash in the bank, buying overseas stocks and commodities or watching your budget and changing price levels. There’s not a lot we can do to change it, but understanding it is important to protect ourselves against the consequences.