Inflation, inflation, inflation. You have heard it many times, for sure. You probably know it has an influence on the economy. But do you really know what it is and how it affects your finances? Let’s discuss it today.
What is inflation?
The simplest explanation of what inflation means is to describe it as an increase in the general level of prices charged for goods and services that households consume. “General” is quite an important word here. Because we are consuming many different types of goods and services. We buy different food, we use electricity in a different way. So the effect of the prices changes will vary from one household to another.
To obtain somewhat standardised results, the Office for National Statistics carries out many surveys. They regularly check what might be in an average person’s basket of goods. And on this basis, they measure changes in the cost of living.
Most of the countries use a CPI-type calculation (Consumer Prices Index) known also as the Harmonised Index of Consumer Prices in the EU. UK uses also the older Retail Prices Index (RPI).
What are CPI and RPI?
Often inflation measured through RPI is higher than CPI inflation. The reason behind it is that the RPI incorporates housing costs as well. CPI does not include those.
There are of course supporters and critics to each method of measuring inflation. Some say the monthly mortgage payment should be included also in CPI. Others argue that housing is not a good but rather an asset.
The formula for calculations of CPI and RPI differs. CPI is calculated geometrically and RPI arithmetically.
The first problem with inflation measurements is whether housing costs should be included or not.
Then, some experts would like to exclude food and energy prices from the calculation. They claim they are too volatile to be in the basket.
Another thing is the quality of the goods. For example, with the same money, you can buy now a far better computer than 10 years ago.
Furthermore, some indications exist that not all country give true information about inflation. Argentina and China are most often listed.
Real and nominal terms
When we talk about values we can distinguish real and nominal figures. Real values are adjusted for inflation and nominal are raw.
For example, investment returns are often provided in nominal terms. You may possess a savings account with a 0.5% interest rate. However, if the inflation rate is 2%, you in fact lose your money because their value is diminishing each year.
The causes of inflation
This inflation takes place when a government or central bank increase the money supply. It stimulates the economy as there is more money in circulation. This results in higher demand and higher prices. The companies begin to make more of their goods. They need more employees. However, the workers want higher wages as all the prices rise. So inflation is high and the economy goes back to its previous level.
This type, known as stagflation, is caused by changes in the cost base and by demand. The prices rise, the wages do not and people are being fired. So both inflation and unemployment are at a high level.
We talk about deflation when inflation is very low or negative. There can be observed fall in the money supply, people buy less and companies make little money. So they need to reduce wages or even fire employees.
Both employment and economic growth decrease. After some time, the prices and wages stabilise at certain levels, but the process is often long and painful for many.
3 ways to protect against inflation
Inflation is a phenomenon that sooner or later will surely occur. It may devastate your portfolio and this is why it is important to know how to protect against it.
During inflation, companies sell their products at increasing prices and this causes higher stock prices. It would be nice to have some equities in your portfolio then. Good choices are for example oil, metals or grains.
Remember, however, the costs of companies’ expenses also rise. Invest in commodity firms or healthcare companies who can be described by low production costs and strong profit margins. Moreover, dividends may bring an increased return to your portfolio during inflation periods.
Buy a house
Real estate seems to be a good investment. Home prices increase in value over time. This is true that occasionally they fall due to real estate bubbles, for instance, however, overall they tend to rise.
Buy a home, keep it for several years and decide whether you want to live in it or you wish to sell it for the better price you have bought it.
Remember about the power in you
One thing you can surely do to be prepared for an unclear future is to invest in yourself. Develop the skills you have or learn something new. Stay up-to-date with what is needed in the world and learn what may help you to stay on two feet in times of instability.
Inflation is an inevitable process. It can be slow and painful. But you can do something to protect yourself from it. In a post-Covid world, inflation forecasts are worrying. Do you have your solution to fighting inflation? Share with us in the comments section below.
All the best!