How Inflation Works And What It Means For Your Wallet

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Most of us have a general idea of what inflation means: Stuff gets more expensive. Of course, inflation is a bit more complicated than that. It plays a pretty significant role in your day-to-day finances, from your income to the cost of your milk to how much you'll earn on your retirement savings.

What Inflation Means, and How It's Measured

Inflation is pretty simple. It's just the rate at which goods and services increase in value, and in turn, at which the dollar drops in value. For example, your latte now costs $5 instead of $4.50, which means your dollar buys less latte. It's the same old latte, but now your dollar buys less of it, so in that way, your dollar has less value.

We measure inflation using a metric called the Consumer Price Index, or CPI. The CPI takes a basket of goods and services, from medical expenses to food to transportation costs, and averages them out to give you a general idea of how prices are changing. When the CPI goes up, that means inflation is happening. Trading Economics shows how the CPI has fluctuated over the years:


source: tradingeconomics.com

You might look at a drop in CPI and think, That's bull. Why are my eggs so expensive, then? But keep in mind: The CPI is an average of a bunch of different goods and services, not just food. If oil prices plummet, that plays a huge role in the overall CPI.

When CPI is stagnant, this means inflation doesn't go up too much, either. Your eggs might be pricier, but in general, you're paying almost the same amount for stuff now as you were a couple of years ago.

How Inflation Affects Your Wallet

Most of us tend to think of inflation as a bad thing. As Investopedia puts it:

It's easy for most people to feel the effects of cost-of-living increases in their daily life. But rising prices hit the lower and middle classes especially hard. Higher food, gasoline and utility costs mean less money remains once these necessities are paid for, leaving little for savings or discretionary spending. To compensate for the rise in prices, consumers tend to buy less, switch to less-expensive substitutes or drive farther to find bargains.

In short, when inflation is up, we feel the strain. We search for ways to be more frugal. We look for bargains. So when inflation is slow, like it has been for the past couple of years, the general consensus is usually that it's awesome. Petrol is cheap! Food prices haven't gone up too much! And in the short-term, this is a good thing. It means we're not paying more for stuff, which means the cash in our wallet is more valuable, at least when it comes to spending.

So it makes sense that inflation generally bums us out. It means stuff gets more expensive, and who wants to pay more for stuff?

Why It's Important to Keep Up With Inflation

If your savings plan is to simply sock away cash under the proverbial mattress, you're actually losing money in times of inflation, because inflation decreases the value of your dollar. Your savings aren't earning any interest, so you're not keeping up with inflation.

For this reason, slow inflation is good news for your savings account, especially nowadays, when interest rates are ridiculously low. The lower inflation is, the more you earn from your interest. Let's assume you have a high-yield (and I use that term loosely) savings account with a bank. You earn one per cent, which isn't much, but hey, at least you still beat inflation in 2015, when the rate only crept up to 0.5 per cent.

By this same logic, inflation is also a good reason to start investing and saving for retirement. The Simple Dollar puts it like this:

Let's say you make $40,000 a year and you're thirty years from retirement. Using a quick rule of thumb, you figure you'll need $1 million in your retirement account to retire. Not so fast. You're actually figuring that million dollars without thinking about inflation. The truth is that with 4% annual inflation, you're going to need $3.24 million in thirty years to equal what $1 million is worth today... Every time you hear an inflation report, remember that it's a call for you to invest for your retirement.

Some will scoff at the idea that investing helps you beat inflation, because the stock market has been in quite the slump lately. But retirement savings aren't based on "lately", they're a return over the long haul. And over the long haul, the stock market has always bounced back and averages about a six to seven per cent return over time.

But if that still sounds too risky for you, there are even specific investments designed to help you keep up with long term inflation. They're called Treasury Indexed Bonds. They're low-risk investments that grow according to the CPI. You won't earn a fortune from them, but you'll at least keep the value of your dollar.

Inflation Keeps Things Balanced

We enjoy super low petrol prices, but that's not all good in the long term. Most economists agree: Inflation is a necessary evil. And, in fact, it's not really evil; it keeps our economic system balanced. It also produces jobs. In his book, Man vs Markets, Economics Explained, Plain and Simple, Marketplace editor Paddy Hirsch explains:

But inflation isn't all bad. In fact, governments quite like inflation — in moderation. Inflation may devalue existing currencies a little bit, but that can be offset by the fact that there's a lot more money coming into the system: money to spend, or invest, or build, or even hire more staff. So, in moderation, inflation can help keep people employed.

This is the basic theory behind the Phillips Curve, which basically says there's an inverse relationship between unemployment and inflation. Theoretically, if inflation is stagnant, that means businesses aren't earning as much, which means they're not paying workers as much, or they're laying them off completely, because the business isn't growing. By that same logic, if inflation goes up, so will spending, and so will employment. If the company you work for is earning more cash, you're more likely to get a raise.

Not all economists agree with the Phillips Curve, but obviously, there's some relationship between wages and inflation, and it's why the Reserve Bank of Australia has an inflation target of two to three per cent. The RBA tries to control inflation by adjusting the official cash rate — the interest rate that affects credit cards, loans and savings rates. According to them, two to three per cent is the sweet spot between hiking up prices way too much and risking deflation. In their own words:

The Governor and the Treasurer have agreed that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3 per cent, on average, over the cycle. This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private-sector inflation expectations.

Lower prices mean businesses suffer, so people lose jobs or stop getting raises, so they stop spending money. Or worse, they run out of money and start defaulting on loans and mortgages. Then, the banks suffer, and the economy is in emergency mode. This is deflation in a nutshell, and to offer an example of deflation, it's what happened in Japan during the '90s.

After a couple of asset bubbles burst in Japan, the country experienced a huge amount of economic stagnation, which eventually lead to deflation. Investopedia sums up Japan's history with deflation:

From 1991 to 2003, the Japanese economy, as measured by GDP, grew only 1.14% annually, well below that of other industrialized nations...Clearly, deflation causes a lot of problems. When asset prices are falling, households and investors hoard cash because cash will be worth more tomorrow than it is today. This creates a liquidity trap. When asset prices fall, the value of collateral backing loans falls, which in turn leads to bank losses. When banks suffer losses, they stop lending, creating a credit crunch. Most of the time, we think of inflation as a very bad economic problem, which it can be, but re-inflating an economy might be precisely what is needed to avoid prolonged periods of slow growth such as what Japan experienced in the 1990s.

In short, inflation isn't always a bad thing. While there are some short-term benefits to cheap prices, in the long run, we need it. Otherwise, it can lead to more systematic, serious long-term problems. Like most things in life, it all comes down to balance.


Comments

    Lower prices mean businesses suffer, so people lose jobs or stop getting raises, so they stop spending money

    But higher prices mean people *need* to keep getting raises to keep up with inflation. Surely if the prices didn't increase, people wouldn't need raises?

      It's a chicken-and-egg cycle.
      - inflation needs to rise to pay for salary rises
      - salaries also need to rise to give people more to spend to keep pace
      - that spending is also what drives inflation

      None happens without the other. And the controlling mechanism is the RBA cash rate.

        But why do people need to keep spending more? Can't we just spend the same amount we always do?

        Heck, are we really spending more if the value of the dollar has decreased? Aren't we really spending the same amount of money, but that's just obscured (until you do some inflation calculations) by the numbers being different?

          How do you not spend more when prices go up?

    This is why you should invest instead of just stick money in a savings account. Your money works for you and increases.

    Some good stuff in here, some alarmist.

    There's certainly no need to run for the hills. The CPI rises by around 0.5 - 1% per quarter (http://www.abs.gov.au/ausstats/[email protected]/mf/6401.0). Which means your latte that was $4.50 last year is now $4.68, not $5. And this isn't always so, as the CPI has had negative quarters recently.

    Beyond this, there are many commodities which are relatively independent of CPI. Petrol is one prime example and is much more governed by the global oil price. This comes down to supply vs demand hence the very (inflation adjusted) low prices over the past couple of years as the US flooded the market.

    You know what this article fails to explain is why inflation happens. It says:
    It’s just the rate at which goods and services increase in value
    But why does that happen? Is it because of the fixation that people have with economic growth?
    I enjoyed reading the article due to the insight it offers about how changes in inflation will affect our daily lives, but what is it that ultimately drives the inflation, and instead of trying to control it via the Reserve Bank, should we be looking at ways to control the unrealistic demand for economic growth instead?

    Last edited 20/07/16 12:06 pm

    As mentioned, it's based on Supply and Demand. If these were always in balance you'd have zero inflation, but as soon as one moves, anywhere, you start the pendulum swinging.

    Demand can increase because of (e.g.) weather - hot weather requires more electricity for running A/C; immigration - more people require more food; greed - I demand more money because I'm special...

    Demand can decrease because of weather - temperate weather reduces electricity demand for running A/C; emmigration - less demand for food and services; greed - overpricing, like health insurance.

    Supply can decrease because of weather - one severe tropical storm at the wrong time and a crop of bananas is wiped out; land use - land previously used for market gardens is sold off for housing development; greed - I'm going to work less so if you want whatever I supply you're going to have to outbid my other customers.

    Supply can increase because of weather - rainfall filling dams and boosting crops; immigration - think doctors and nurses; technology improvements - better land use, or automation replacing unreliable part-time humans with highly reliable robots...

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