“By a continuing process of inflation government can confiscate , secretly and unobserved , an important part of the wealth of their citizens” – John Maynard
What is inflation?
The formal definition or understanding of inflation is regarded as ” the fall in the purchasing value of money”. So what exactly does this mean? I love to explain concepts through examples , so lets have a look at one. So lets say for the purpose of this example in 1920 people earned an average salary of R100, and on that salary they were able to pay for a house, for a car, groceries and other bills. That same R100 today definitely can barely buy anything and most definitely it cannot cover your average household bills. Now the question is why is this ? The reason behind this is inflation.
Inflation, is not only the deprecation in the value of money, the whole situation is worsened by the fact that the price of goods and services goes up. If you ever get the opportunity to look at the price of homes on the early 1900’s, you will see that luxury homes were priced around R20 000. From what I know you cannot even buy furniture to for your home with R 20 000.
What causes inflation?
There are different factors that influence the rate of inflation. This is the most important thing to note, different economies have different inflation rates. The better the economy the lower the rate of inflation. Here are some of the factors that cause inflation :
- An increase in the demand of products, when there is a low supply on the products.
- An increase in the price of the product as the result of an increase in the costs needed to produce the product.
- A depreciation in the value of money as a result of an increase in the money supply ( this is when the government starts to over print money, a good example of this is Zimbabwe).
- The reason money can be overprinted is to compensate for the national debt, therefore an increase in the national debt can be considered as contributing factor towards inflation.
- The exchange rate between two currencies can also contribute towards an increase in the inflation rate.
How to know what is the rate of inflation?
Have you come across the term CPI? Its not uncommon to flip through the news and they are talking about the CPI? The CPI is an index and it measures inflation. To avoid being unnecessarily technical, the CPI is an index that measures the average spending taking place in a country , and it uses these metrics to determine the rate of inflation. The ideal rate of inflation is between 2-3% , anything above this is considered respectively high.
You can use the economic calendar available in the link () to get the latest updates in the CPI for South Africa. Also make sure to subscribed to the newsletter , you can do so following the link ().It is important to understand the role of inflation in the economy, because it brings risks and benefits that can impact your personal finances.
The risks that are brought with inflation?
The most negative effect of inflation is that it decreases the purchasing power of your money , and therefore it can reduce the value of the return on your investment. Lets look at an explain. For the purpose of this example you invest a R 1 000 000 over the next 10 years, with the expectorations to grow the R 1 000 000 to R3 000 000. Lets for the purpose of the example say I start investing in 2019 , and there is an exuberantly high inflation rate at the time, so high that at the end of 2029 when I liquidate my position and get my R 3 000 000 it has the same value of R 1 000 000 in 2019. It is dramatic decline in purchasing power makes it an unsuccessful investment . This is an extreme example , but not impossible. Perhaps an example that is too close to home, would be people who invested in the Zimbabwe Stock exchange and lost their investments due to exuberant inflation rates in 2008.
The benefits of inflation?
It may be hard to believe that there are benefits of inflation , but best believe it there are. One of the biggest benefits of inflation, depending on other economic factors such as interest rates, inflation can often make paying back debts cheaper. You will only be able to benefit from the opportunity offered by inflation if you have adequate savings and have been well prepared and been made bullet proof for inflation.
Fun facts about inflation:
Inflation makes paying your debts cheaper – How you ask?
Inflation is effectively the depreciation in the buying power of money. Therefore in order to understand how inflation can make your debt cheaper, do not think about debt as money, but instead as an object such as a car. Like a car the debt you owe depreciates because of inflation the less value it has. Just as you when you buy a used depreciated car its cheaper, so is paying back your debt, as the value of that loan has decreased as a result of inflation. The face value may appear to be the same , but the value of the money has been reduced.
Note that this does not apply to debts that are subject to an adjustable interest rates. Where the loan is subject to an adjustable interest rate , the interest rates will be increased automatically to match the rates of inflation.
Inflation is the reason why keeping your money in a saving account could be a really bad idea.
In the case of a saving account , your money similar to a car that leaves the dealer shop immediately starts to loose value when it simply sits in the bank. As the money sits in the bank it is subject to inflation and this is not offset by the extremely low interest rates offered by the bank. Ideally a money market fund is a better option to use rather than a saving account how to save, also you can consider splitting your cash between a saving account and money market fund. This way you can still get the benefits of a saving account, as well as mitigate the risks your money may face being subject to inflation.
How to beat inflation
- Invest in assets that offer returns that offset and out perform the inflation rate. Perhaps an obvious investment asset that will help you fight the negative effects of inflation would be an Inflation-Linked Bond ETF. Consider using money markets funds as an instrument to host your savings oppose to a saving account.
- Always have a adequate money saved away to avoid entering any financial problems.
- If you have debt , make sure that its subject to a fixed interest rate and not an adjustable interest rate.