What is Inflation? And Why you Should Be Concerned…
Last week, I had a great conversation with a mate whilst we were away for the Easter long weekend. Simply put the conversation was about why the Reserve Bank of Australia was hiking interest rates so high and so fast, causing massive heartache and problems for those with mortgages.
Now, I am not an economist, but based on my studies, I have been able to learn a thing or two about the macroeconomy. Therefore our conversation, simply put, tailored around interest rate hikes not just being about inflation, even though it is the core reason for increasing rates. But today, we don’t want to go into the intricacies or the complex system that makes up our macroeconomy and interest rate decisions, today we simply want to understand…
What is inflation? And why should you be concerned with increased levels of inflation?
Firstly, let’s take a look at the defintion of inflation and then lets unpack it from there.
The Reserve Bank of Australia (The institution involved in trying to stabilise the economy and the Australian currency) states, “Inflation is an increase in the level of prices of the goods and services that households buy. It is measured as the rate of change of those prices. Typically, prices rise over time, but prices can also fall (a situation called deflation).” [1]
Therefore, we can safely say that inflation is based on the increase of goods and services across the economy, as resources, wages and spend on research and development increase, the cost of creating a product or service also increases.
The increased cost of products and services will get passed on by companies and businesses to the consumer (us), so that way the extra cost does not eat into their profits significantly, because without profit, the company would eventually lose shareholder sentiment and after a while lose the ability to remain solvent.
Hence, a low level of inflation is seen as progress, it keeps the economy of a country moving forward and growing. We have had this in Australia for the last 10-15 years, whereby inflation levels have been constantly sitting between 2-3%.
However, over the last twelve months, we have seen inflation grow to the highest levels since 1990, whereby the annual inflation rate for the December 2022 quarter was sitting at 7.8%. (See graph below)
Australian Bureau of Statistics (ABS, 2022) [2]
Now we know what inflation is, or roughly know that it is the increase of prices of goods and services on average across an economy, why should we care?
Other than the obvious reason that no one wants to see prices going up and up all the time.
Inflation, at the extreme level, can be detrimental to the stability of an economy, if you see abnormal levels of high inflation for a long period of time (Such as hyper-inflation) consumers will grow to expect everything will just keep getting more and more expensive. The expectation alone creates a self-fulfilling prophecy, whereby consumers will want to buy things now, before it goes up in price, increasing demand and therefore increasing prices again. Causing even higher inflation.
We have seen this happen in Argentina over the last twenty to thirty years, whereby they just hit over 100% inflation [3], considering our measly 7.8%, we don’t seem to be doing all that badly.
However, for those living in Argentina, they are seeing daily price swings of 10-50% on essential items, such as groceries and electrical goods. The Argentinian Peso, the currency used in Argentina, is seen as absolutely worthless, to the point where people don’t have any cash in the bank anymore.
There has been countless countries who have gone through hyper-inflation, starting in the Wiemar Republic in the 1930’s and more recently in Turkey and Zimbabwe.
Which brings me to why you should be concerned about inflation and why the RBA has been jacking up interest rates to bring it under control…
The higher inflation gets, the less your cash in the bank is worth.
Let’s use an easy example, one a lot of younger Australians are struggling with right now, the housing market.
A young couple who are trying to save for their first home are saving in cash, but the annual savings rate of cash for most banks currently is sitting between 4% to 4.6%. Whereas the inflation rate is sitting at 7.8%, meaning that your cash is losing value at 3 to 3.6% per annum.
Just by saving your money in cash, you are currently losing purchasing power, as inflation and price growth is outstripping savings growth. Therefore, the couple get desperate, they need to buy now, before housing goes up even more. That is where they go to a bank to get a mortgage, that way they can buy now and will be able to save on any potential increases in prices in the housing market over the next twelve months.
Due to buying now, rather than waiting, this has increased the demand of housing, as more people want to buy more houses. With higher demand, we have what we call a market pull, whereby demand is pulling prices higher.
In turn, creating that self-fulfilling prophecy of increased inflation I was talking about earlier.
We can see this in the price of goods and services as well, whereby 100 people want to buy one thing, but there is only enough supply of the goods or service for 90 people, this is what jacks up prices and causes inflation.
Now, there are multiple other reasons too much inflation is a bad thing, but that is one of the main reasons we have seen interest rates increase significantly over the last twelve months.
Now, inflation has been decreasing in Australia, but we wont see the real effect’s of the increased interest rates truly until the end of this year.
So what could you do to make sure you do not lose purchasing power over the next decade?
One thing you can do if you want to make real nominal returns over the next ten years is invest in the Share market, whereby there has been an average return of 9.8% per annum over the last ten years in the ASX 200 (A group of the top 200 companies in Australia).
By investing in shares, you will not see your cash get eroded away by inflation over the long term, rather you will see your purchasing power increase.
Of course, the Share market is a lot more volatile and you need to be in the market for a long period of time to see the returns to stay above inflation, but if you have a long term horizon and want to do what the wealthy do, invest your money in shares and stay a step ahead of inflation.
Until next time,
Take Back Control
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[1] - https://www.rba.gov.au/education/resources/explainers/inflation-and-its-measurement.html
[3] - https://tradingeconomics.com/argentina/inflation-cpi
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