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What is inflation and how does it affect me?

What is inflation and how does it affect me?
05-07-22 / Jaco Prinsloo

What is inflation and how does it affect me?

Many South Africans are concerned about the ever-increasing inflation rate, and always talk about inflation driving up the cost of food, fuel, and living expenses and eroding buying power, with salaries not stretching as far as they once did.

Inflation is an economic term that refers to a general increase in prices and a decrease in what you can buy with your money. It is a term that means you have to spend more over time to fill your petrol tank, buy a litre of milk or get a haircut.

There are two types of inflation:

  • Demand-pull is the increase in the general price level of goods and services resulting from consumers spending more (demanding more).
  • Cost-push is the increase in the price level of goods and services resulting from production inputs that have become more expensive (products costing more to produce). 

How does inflation affect interest rates? 

There is an inverse relationship between interest rates and inflation. When interest rates are low, inflation generally rises. Therefore, if inflation is rising faster than a central bank prefers, policymakers might try to combat it by increasing interest rates. This shows that rising interest rates are a monetary policy response to rising inflation. If inflation drops below the target rate, policymakers might lower interest rates.

Lenders will also demand higher interest rates as compensation for the decrease in buying power of the money they are paid in the future. 

What does high inflation mean to my investment? 

When inflation is higher than the returns you get on investments, your money is worth less than before. High inflation reduces the value of your investment because it erodes the buying power of future income. 

How do different investment types perform in a high inflation period? 

Fixed, long-term cash flows like government bonds tend to perform poorly when inflation is rising since the buying power of those future cash flows falls over time. 

Correspondingly, commodities and adjustable cash flows such as property rental income tend to perform better with rising inflation.

Inflation-indexed bonds are designed to protect investors from inflation (an inflation hedge) and generally do well in a rising inflation environment. 

Historically, gold and shares seem to be a good line of defence when inflation is above 6% while cash and longer duration bonds generate negative returns.

What is deflation and why is it bad?

Deflation is a general decrease in the prices of goods and services in an economy. This is a sign of a weakening economy (weak demand). Companies respond to falling prices by slowing down their production, which leads to layoffs and salary reductions.

Pros and cons of high inflation

The benefit of inflation is not necessarily because of inflation itself but from economic growth and employment associated with it. This highlights the important balancing act of monetary policymakers, which is to balance their objective of higher employment and a stable economy with price stability and managing inflation, without going into a deflation situation.  

High inflation often leads to:

  • lower growth
  • less price stability
  • lower future wage buying power
  • uncertainty
  • less foreign direct investment

What can you to do mitigate inflation?

As prices keep on rising due to economic factors, there is little you can do against inflation except changing your behaviour as a consumer. Try to lower your monthly expenses – see if you can renegotiate your insurance or cancel unused contracts. Increase your income by becoming more valuable in the workplace or by finding extra income streams. Speak to a certified financial planner to make sure your investments are diversified and in line with your income, expenses, investment time horizon and risk appetite.

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