What is inflation?

Inflation is the price increase in goods and services which links directly to the loss of purchasing power of your currency. To explain the loss of purchasing power, let's use an example of a shopper buying food with 100 of any currency. Next year as inflation increases(prices increase), the same 100 will buy fewer items from that same shop. This is the loss of purchasing power. If your assets or income is not keeping pace with inflation, you are getting poorer in the war with inflation. 

Before 1971 the world had a gold standard whereby all money in circulation was backed by the same physical amount of gold in a bank vault, this meant your money was backed by a physical asset. The gold standard had its flaws but its great benefit was that it prevented inflation by not allowing governments and banks to manipulate the currency by money supply. In modern times we also call this quantitative easing where governments print money at will. In 1971 when President Nixon abandoned the gold standard, inflation became public enemy no 1.

What are the causes of inflation?

There are two main drivers of inflation, both work from a different angle but both create inflation. 

1. Demand-pull inflation: When demand for goods and services is more than the supply, prices for these goods and services will increase, causing inflation. This type of inflation is common in growing economies, where people get better jobs and income, and they spend more. 

When the money supply increases i.e printing money (expansionary monetary policy) it generally lowers the value of your currency, which means import costs rise. The second way to increase the money supply is by lowering interest rates to make credit cheaper, this “cheap money” scenario causes inflation as more money is buying the same amount of goods and services. 

Currently, the world is seeing a scenario where the USA is trying to solve their inflation by increasing interest rates which is a big problem as it's not that they increase their money supply, but rather the USD strengthening causing the emerging currencies to lose value and create inflation worldwide as it makes US Dollar imports more expensive. Emerging markets don't have the luxury to increase the money supply as it will create hyperinflation such as in the story of Zimbabwe 

2. Cost-push inflation: When supply issues cause disruptions or there are expected or unexpected increases in the production of a good or service, the supplier can increase the price of their product. This is cost-push inflation. Examples of these are bottlenecks in supply chains, monopolies charging what they want and natural disasters causing havoc in the supply chain. One of the best modern-day examples of cost-push inflation is the increases in shipping costs post covid, as massive backlog and other issues caused the price of shipping to skyrocket.

How high is inflation?

Inflation is calculated by comparing a “basket” of goods and services at one point to another point in time. This basket contains various items such as bread, milk, ready flour mix, car rental, and video games. In S.A we have 412 items in this inflation basket. The increase in this basket of goods and services is how inflation is calculated by the reserve bank.

At the end of September 2022, the inflation in the USA was at 8.2% and 7.5% in South Africa. 

USA long-term inflation: As you can see below, inflation in the USA hardly ever goes above 5% making the current inflation number the highest number since the early 1980s. History in the making. 

South Africa's long-term inflation: As you'll notice inflation was high pre-2000s era. In Feb 2000, the South African reserve bank started inflation targeting and aimed to keep S.A inflation between 3%-6%. South Africa uses interest rates (monetary policy) to keep inflation in range. 

How to calculate my inflation?

The inflation numbers we see above is the official inflation number provided by the reserve banks. This does not mean that this is your inflation rate, as you will use different items in different amounts compared to other people. Your inflation will differ accordingly. Let's look at an example: 

Our example inflation basket of goods and services comprises meat, veggies, fuel, electricity, and clothing. How simple would such a life be right?  

In the last year, the price of meat increased by 15%, veggies by 5%, fuel by 18%, electricity by 5%, and clothing by 10%. 

Person X: He uses an e-bike to get to work, he is a vegan and did not buy any new clothes this year. If we equally weigh his inflation it would be 5% as he was only affected by the increase in veggies and electricity which went up by 5% each.   

Person Y: He eats meat, drives a big bakkie, and buys clothes every month. If we equally weigh his inflation it would be 14.3% as he consumes more of the inflationary items. 

Comparing the above two people you will notice that their inflation won't be the same. Person X will have a lot lower inflation number than person Y and will feel the effects of inflation less. As per this simple example, every person will feel inflation differently depending on what they spend their money on and the price increase of those goods and services. 

How does inflation affect my standard of living?

In short, inflation increases prices and you lose the purchasing power of your money. This could affect your daily trips to the grocery store and even your savings at retirement which has to keep pace with inflation.  

The point is that inflation is enemy number 1 for all of us. If our income, assets, and investments don't keep up with the pace of inflation, we are losing wealth. 

A quick example: If inflation is 7.5% and you earn 5% in the bank you are losing 2.5% purchasing power, meaning you are losing wealth. Instead of looking at the gross return, you are receiving (5% in this example), rather take the inflation number and look at the REAL return. This will give you a good measure of how your wealth is performing as it takes into account the effect of inflation.

Another interesting way that traps the average person in thinking they have created wealth is that if asset prices go up, is it due to the value increase of that asset, or is it just your money losing purchasing power? You might be fooled into thinking your home increases by 6% per year, so the value of your house looks more on paper, but if inflation was 6% over this period, your house did not increase at all. 

How do I protect myself against inflation?

You need to ensure that your income is keeping pace with inflation and that your money is invested in assets that at least keep pace with inflation and protect against inflation increases. A good example is property. If inflation increases, the property should keep pace with inflation and the rental can be increased with inflation over time making property one of the great inflation-hedging assets. There are plenty of these assets, the goal is wherever you invest, ensure it provides returns above inflation i.e. real returns. 

In summary

You will become a better investor now that you are aware of inflation, and how it affects you, and that you should focus on real returns. Stop and think twice before making financial decisions to ensure that inflation is planned for. Our current economy allows for inflation, so educating yourself about the topic is crucial to navigating the money world. We can beat the war againts pucblic enemy no 1.

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