Retirement Life
13 June 2022

Understanding Inflation

After a long period of record-low inflation, it is clear we are in a new economic cycle. Liz Koh explains more and outlines where we may be heading.

 

The Consumers Price Index (CPI) increased by around 7 percent in the year ended March 2022. The last time we saw inflation at that level was in the late 1980s. Most of us remember those times. We struggled with high mortgage interest rates and rapidly increasing prices. It was tough going then. So where are we heading now? To answer that question, we must first go back to basics and understand what inflation is and what causes it.

 

Inflation is simply the rate at which prices of goods and services are increasing. It is measured quarterly by changes in the CPI. The CPI is calculated by measuring the prices of a ‘basket’ of goods and services which a household would typically buy. This includes such items as food, petrol, rent, home maintenance, rates, health costs, and a raft of other items. The items included in the basket are determined by a survey of actual expenditure of a sample of households. Spending patterns change over time. For example, less is spent now on tobacco, but more is spent on exercise equipment and surgeons’ costs.

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There are two prime causes of inflation. The first is an excess of demand over supply – that is, where there is too much money chasing too few goods. This is called ‘demand-pull’ inflation. The second cause is when there is a change in the costs of materials or other resources that are used to make goods and services. This is ‘cost-push’ inflation.

 

Over recent months we have seen evidence of both these causes. When COVID-19 struck, the Reserve Bank’s response was, in simple terms, to increase the amount of money in circulation and lower interest rates to encourage consumers to buy and businesses to invest, thereby preventing a recession. Consumers certainly made the most of it – spending money on new cars, new kitchens, landscaping, new furniture, and so on.

The level of spending was helped by the fact that people could not travel overseas, and cars and kitchens became a substitute for cruises. Gib board was the often-quoted example of demand-pull inflation. There were problems with the supply of Gib board, combined with unprecedented demand for building materials, and the price went through the roof. Alongside this came a significant change in oil and food prices, resulting in ‘cost-push’ inflation. Oil is an input to the production of many goods and services as well as being used to fuel our cars.

 

A small amount of inflation – around 2 percent – is good for an economy, as it signals economic growth. However, inflation such as we are experiencing now is bad. People are left worse off if the cost of goods and services increases by more than their incomes. The value of investments (for example, bank deposits) can fall if the investment return doesn’t keep up with inflation. In the longer term, the uncertainty caused by rapid inflation affects economic growth because businesses become reluctant to enter into long-term investments and contracts.

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The Reserve Bank has an agreement with the Government that it will aim to keep inflation within the range of 0-3 percent over the long term. The key tools it has to achieve this objective are to push up interest rates and to issue Government bonds that are purchased by banks and other wholesale investors (thus taking money out of circulation). Doing this has the effect of reducing the demand for goods and services. The Reserve Bank will need to strike a balance between pushing hard and fast to lower inflation, while ensuring the economy doesn’t enter into a recession. A gradual reduction in inflation may lead to a better outcome in this regard. This means we can probably expect to see higher inflation continuing in the medium term.

 

For investors, higher inflation means seeking out investments with a rate of return that is more likely to exceed the rate of inflation in the medium to long term. Bank term deposits are unlikely to achieve this goal. Rising interest rates lead to falling bond prices, so investment in bonds needs to be undertaken with caution. Property has the advantage that rents tend to rise with inflation. However, higher interest rates, along with other factors, will lead to falling property values. This need not be an issue for property owners unless there is an intention or a need to sell. We know that over the long term, shares are the most likely asset class to generate a return that keeps up with inflation, however, the current market volatility is a deterrent to many.

All this leads to the following conclusions:

 

  • In these times of economic transition, there is no stand-out investment class.
  • As usual, a diversified investment portfolio will help with reducing investment risk while achieving a good investment return in the long term.
  • Having a buffer of cash in the bank will help ride out any short-term market changes.
  • Investors who rely on their investment returns to supplement income will probably need to use up capital to keep up with rising living costs, while also keeping strict control of household budgets.

 

There are tough times ahead in the short term, however, over time the economy should transition to a period of greater stability.

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Written by:

Liz Koh

Liz Koh is a financial planner and specializing in retirement planning. The advice given here is general and does not constitute specific advice to any person. A disclosure statement can be obtained free of charge from www.enrichretirement.com

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