Anyone who turns on the news or shuffles through a newspaper will know that the word inflation comes up quite frequently. But what does it mean really and why we should care about the reasons behind it going up or down? No subject is as much discussed today, yet so little understood as inflation. The politicians talk about it as if it were an unwanted alien visitation from another planet over which they had no control while the Central Banks around the world always vow to “fight” it to maintain economic prosperity. With this blog, I’ll try to give you a background on what inflation really means, the factors that drive inflation up or down, and the implications it can have on your life and in your investments.

While prices change all the time, when the price of one item goes up, we don’t necessarily think about its relationship with inflation right away. Instead, we say there is inflation when the prices of many goods or services we buy rise at the same time and then continue to rise. Put differently, inflation is ongoing increases in the general price level for goods and services in an economy over time. Inflation, as a figure is quoted in percent, so if someone says ‘inflation is expected to be at 3%’ what that actually means is that next year something that costs you €1.00 today, is expected to cost you €1.03. For us millennials, an example of inflation would be the price of our favorite chocolate bar going up over the years – the sweet impact of inflation.

If we step back from our sweet tooth for a moment and look at the economy as a whole, you might be wondering how inflation is measured. The government measures the overall change in prices of all goods by using the “Consumer Prices Index”. The CPI is a representative basket, also called the market basket, including a fixed list of items such as food, housing, apparel, transportation, electronics, medical care, education, etc. whose price data is collected periodically. This data is then used to calculate the inflation levels in an economy. When economists and central banks talk about inflation, they generally focus on “core CPI” or “core PCE”. Unlike headline inflation, core inflation excludes food and energy prices that are more prone to sharp price swings and could therefore give a misleading picture of long-term inflation trends.

If you are asking yourself why you should care about inflation, it is simply because by keeping your eye on inflation, you will know how much your income is losing in spending power and what your savings and/or investments should make to stand against the impact of inflation.

In the growth stage of an economic cycle where businesses grow and consumers spend more money on goods and services, demand typically outstrips the supply of goods, and producers can raise their prices. As a result of this temporary scarcity where people scramble to purchase a limited supply of goods, the rate of inflation increases. Another situation in which inflation occurs is when businesses and manufacturers increase their prices due to higher production costs. Rising labor costs, raw materials, and transportation expenses are examples of factors resulting in an increase in production costs. Usually, these costs are then passed on to customers in the form of higher prices. Finally, inflation can also occur as a result of the increase in money supply – not just cash but also credit cards, personal loans, mortgages, and investments. The housing bubble of 2005-2007 driven by the run-up in housing prices could be an example of too much money in the system. Low interest rates, relaxed lending standards—including extremely low down payment requirements—allowed people who would otherwise never have been able to purchase a home to become homeowners instead of renting, driving home prices up even more. And afforded by low interest rates, homeowners used their equity elsewhere spending their monies on other goods such as cars, TVs or even more houses. Deflation, on the other hand, occurs when there is a decrease in the general price level of goods and services, in other words, deflation means negative inflation and technically speaking deflation happens when the inflation rate falls below zero.

So how much inflation is the right amount to keep everything in check? While theoretically speaking there are opposite camps of economists who have varying opinions on what the optimal level of inflation should be, the important thing to know that inflation is not necessarily evil and mild inflation in the range of 2%, as settled upon by the Central Banks around the world, could be in fact good for the economy because it can grease the wheels of consumption without destroying the value of people’s savings. On the other hand, runaway or hyperinflation, the period of fast-rising inflation could have detrimental effects on consumers’ standard of living triggering a downward spiral of the economy. Another type of inflation, stagflation, is when prices rise amid stagnant or non-existent economic growth, which was back on the radar during the pandemic in the wake of unprecedented levels of stimulus pumped into the markets by central banks combined with Fed tolerating a spike in inflation versus economic growth hampered by the strict lockdown and other preventive measures imposed by the governments.

In summary, I hope I was able to explain some of the basic principles behind inflation. More importantly, I would like you to have one key takeaway from this narrative, which is no matter the level of inflation, investing is how you generate real returns, meaning the returns minus the inflation. While we can’t predict inflation, we can at least equip ourselves with what we know today, use it to our advantage, use this time to increase our savings by investing in appropriate investment avenues while diversifying to beat inflation. If you would like to find out more about other economic indicators make sure to read our blog article Top 10 indicators to watch out for.