Inflation: it can be confusing. But fret not, a WTF post is here to save the day.
Inflation is important to understand a large part of the economics in a country. It also helps to understand interest rates and even how the stock market works. It’s an essential part of building your financial intelligence.
Here’s what we’ll be covering today:
- What is this inflation??
- What causes it
- Why it’s used
- How it’s calculated
- What you can do about it
What it is
Put simply, inflation is the rate of increase in prices for goods and services. So basically, things getting more expensive over time. This year your croissant will cost you £2, next year it may cost you £2.06.
This +£0.06 in cost is normally expressed in percentage: 3%. So we say that next year inflation will be at 3% because prices will be 3% higher.
There are different types of inflation:
Hyperinflation: inflation which is more than 50% a week (some examples)
Stagflation: inflation happening at the same times as a recession (an example)
Asset inflation: rising prices of housing, gold or stocks (an example)
What causes it
I honestly didn’t really know what caused inflation until I did a bit of research. Turns out it’s all about consumerism: supply and demand.
The most common cause is something called demand-pull inflation. This happens when there is more demand than supply:
6 people want to buy croissants but there are only 4 left. The bakery rises the prices to £2.06 so only those willing to pay more will buy their croissants (yes £0.06 is not much but this is an example ok).
Another cause is cost-push inflation: supply is restricted but not demand. This happens when something like a natural disaster takes place and supply is restricted but people still want their stuff.
There’s a huge snowfall in the city and the bakery can’t get the croissants over, so they’re stuck with 4 croissants. They raise prices to deter those who can’t afford it.
You may think: huh, both cases are the pretty much the same. They really are, what changes is the reason for low supply. In one case it’s simply high demand and in the other it’s lack of supply.
It’s nice and easy to understand with the bakery situation, but now picture it with a government, business and an economy in the middle. These are other factors that cause inflation in the economy:
- Government lowering taxes: lower taxes mean higher income - people can spend more which means higher demand.
- Deliberate devaluation of the currency (government hops in and adjusts the exchange rate): by making our currency cheaper, other countries are more interested in buying goods from us - higher external demand.
- Surplus of liquidity: printing more money - people have more money so they spend more and so there’s a higher demand.
So as you can see, inflation is the result of money moving around the country and the demand of the people. It’s human desires and needs that move the money - inspiring.
The most extreme examples of this happening is in Weimar Germany in 1922 when the daily inflation rate was 21%. People were literally hauling wheelbarrows of bank notes - and the value was still low. Nowadays this is happening in countries such as Venezuela and Mozambique.
Why it’s important
Inflation affects pretty much everything in the financial services sector.
Banks use it to determine how much demand there is for loans, for example. If they see that there is a high demand and that inflation is at 3%, they will adjust their interest rates to match that demand.
Companies use inflation to determine their employees’ pay rises, product prices and annual spending.
Governments use it to determine how the economy is going, whether people are consuming more or less and how they should deal with the situation.
How it’s calculated
You have two metrics when calculating inflation:
CPI - Consumer Price Index: cost of consumer products: food, entertainment, travel, etc
RPI - Retail Price Index: same but also includes mortgage payments and council tax
How is it calculated exactly? Every month a corporation called the Office for National Statistics (ONS) collects over 100,000 prices of different goods and services. Prices are monitored and then combined with household spending patterns to produce an index.
Some products are given more importance than others; we spend more on petrol than croissants, for example, so petrol might make up 3% of the index whereas served food may make up 1.5%.
What’s pretty cool: you can see the inflation rates yourself on the ONS page. There are some pretty informative charts and it tells you what the inflation rate has been in the past year (2.7% btw). And there are some other cool statistics: % of people shopping online, the fact that London has the highest percentage of people identifying as gay/lesbian/bi and the percentage of offences involving weapons. This website has it all (you could literally spend hours on it).
What to do about inflation
Inflation can be dangerous, an invisible tax thief that slowly pockets your money. Especially to savers: you save up £5,000 in your bank account - great. Next year inflation rises to 3%, that means that your £5,000 is worth 3% less and you’ve essentially lost £150 (3% of £5,000). It may not seem much to you but this amount accumulates over time and next thing you know you’ve lost £1,000. Not so funny.
Inflation eats away at your money, so you want to be sure your money is protected and won’t be too badly affected. Here are some ways to protect your money:
- Property investing: as housing prices rise, so will your tenants rents. You’re safe.
- Index funds: with an average return of 7% on your money, after inflation it will be 5%. Better than -3%.
- Buy gold: people turn to gold when inflation rises (touching the value makes them feel safer), increasing the price of gold - could make a neat little profit there.
- Invest in oil: similar to gold, oil is a essential for humans to move around, and so will always have value. People turn to oil when inflation is rising - another neat little profit.
So as you can see, it works with the emotions of the people. Inflation rises, people get scared and they go off and invest in gold, oil and other commodities. So if you buy before that happens and sell at a high price… the ££ can be pretty sweet.
But unless you have a lot of money saved up somewhere, you don’t have to worry too much about inflation as a student. It’s still good to know for the future - inflation is an invisible thief.
As I’m writing this (16/04/2018), we’re still in the long bull market of the past several years: inflation is low, so interest rates are low and wages are stagnant. However, in the past month or so people have been talking about rising interest rates, and I’ve received a few emails from companies warning their clients of increasing prices (thanks Sky). But you know what that means? Inflation is going to start increasing… maybe now’s the time to do a bit of research and see how one can benefit from inflation…
What’s one specific example of inflation you can think of? Anyone remember the 20p Freddos?
