Inflation explained: Here’s how it affects you and your investments

How does inflation affect consumers? Month after month we hear about inflation and that it is increasing currently, but few people know why they should care, apart from the fact that they can feel their money having to stretch further as inflation increases.

“Inflation is an economic term that means you have to spend more over time to fill up your car, buy a litre of milk or get a haircut,” says Jaco Prinsloo, certified financial planner at Alexforbes.

He explains that inflation drives up the cost of food, fuel and living expenses and erodes your buying power. Your salary is not stretching as far as it once did due to inflation.

There are two types of inflation:

• Demand-pull: the increase in the general price level of goods and services due to consumers spending and demanding more
• Cost-push: the increase in the price level of goods and services because it is costing more to produce goods and services.

ALSO READ: May inflation highest in 5 years due to food and fuel prices

Inflation and interest rates

Inflation and interest rates are closely related and consumers would have noticed that inflation generally increases when interest rates are low.

“Therefore, if inflation is rising faster than a central bank prefers, policymakers can try to combat it by increasing interest rates. Increasing interest rates is a monetary policy response to rising inflation.”

As soon as the Monetary Policy Committee (MPC) of the South African Reserve Bank (Sarb) increases the repo rate, lenders will increase their interest rates as compensation for the decrease in buying power of the money they are paid in the future.

When the inflation rate drops below the target rate of 6% in South Africa, policymakers might lower interest rates.

In short, when inflation increases, you are forced to pay more interest on your debt and you have even less money to spend.

ALSO READ: Even higher inflation and repo rate means more consumer pain ahead

How it affects investments

Although many consumers who have investments or savings believe they benefit from higher interest rates, Prinsloo says when it is higher than the returns on your investments, your money is worth less than before as high inflation reduces the value of your investment because it erodes the buying power of future income.

“Fixed, long-term cash flows, such as government bonds tend to perform poorly when [it] is increasing as the buying power of those future cash flows decreases over time. In the same way, commodities and adjustable cash flows, such as property rental income, tend to perform better with rising inflation.”

Prinsloo says inflation-indexed bonds are designed to protect investors from a hedge and generally do well in a rising 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.”

Shocking inflation rate increase for May spells more trouble for consumers

What is deflation?

Deflation is another term that is used more often.

Prinsloo explains deflation is a general decrease in the prices of goods and services in an economy and is a sign of a weakening economy and demand as companies respond to falling prices by slowing down their production, which leads to layoffs and salary reductions.

Does anyone benefit from it? Prinsloo says the benefit 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 rates often leads to lower growth, less price stability, lower future wage buying power, uncertainty and less foreign direct investment, he says.

Inflation on the rise, but not expected to go too far beyond 6%

What can you to do mitigate inflation?

Prinsloo says as prices keep on rising due to economic factors, there is little you can do against the spike except change your behaviour as a consumer.

He suggests trying to lower your monthly expenses, such as renegotiating your insurance or cancelling unused contracts.

You can also try to increase your income by becoming more valuable in the workplace or by finding extra income streams.

“You can also 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.”