08 Aug 2022

A crash course in inflation

A crash course in inflation

Inflation causes your money to lose its purchasing power. Your money today buys less than it did a year ago for example

In this short article, we look at what inflation is, the different types, what is causing it and what you can do about it.
Firstly, What exactly is Inflation?

It is the rate of increase in prices over a given period of time. It is a broad measure which calculates the overall increase in prices or the cost of living. Simply put inflation causes your money to lose its purchasing power. Your money today buys less than it did a year ago for example.

There are 3 main categories or ways that inflation is caused:  demand pull, cost push and built-in.

1) Demand-Pull Effect
Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy's production capacity.  This increases demand and leads to price rises.

With more money available to individuals, positive consumer sentiment leads to higher spending, and this increased demand pulls prices higher. It creates a demand-supply gap with higher demand and less flexible supply, which results in higher prices.
This type of inflation could be seen in the Irish property market and also the post pandemic pent-up demand for holidays, flights and entertainment etc.

2) Cost-Push Effect
Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channeled into a commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodities, costs for all kinds of intermediate goods rise.

These developments lead to higher costs for the finished product or service and work their way into rising consumer prices.
Examples of this type of inflation have been caused by shortages in the supply chain following the lockdowns during the pandemic and unfortunately events in Ukraine.

3) Built-in Inflation
Built-in inflation relates to the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs or wages to maintain their standard of living.

Their increased wages result in a higher cost of goods and services, and this wage price spiral continues as one factor induces the other and vice-versa.
Why are we hearing so much about inflation at the moment?
Recently produced figures from the CSO (Central Statistics Office) show that prices in Ireland rose by 7.8% in the 12 months to May. This is the biggest increase in 38 years!

Why is it so high at the moment?
Pent up post pandemic demand is one factor. Post lock downs there is huge appetite to socialise and travel again pushing up the prices of flights and accommodation etc.

Gaps in the supply chain and shortages of materials also caused by pandemic lockdowns are another factor and unfortunately the events in Ukraine are having a big impact on energy and food prices.
Headline increases over the last year
Electricity +41%
Gas +57%
Heating Oil + 102.5%
Diesel + 41%
Petrol +30%
Air Fares +45.4%

On top of all of this the ECB has just increased rates for the first time in 11 years by 0.25% and more increases are expected.
What can you do to protect the value and buying power of your cash?
Investing in the stock market is one way to beat inflation over the long term. Individual shares may fall, some companies may go out of business and bear markets can depress indices for periods of time but the broader stock market indices usually rise over the long-term beating inflation.

For 100 years from 1920 to 2020, the US S&P 500 which is the broadest measure of the US market and tracks the performance of 500 of the largest companies in the US, returned an average annual return of just over 10% with dividends reinvested.

This is the long-term average and over that period there were many years with lower or even negative returns.
Investing in a well-diversified broad market index fund can grow wealth over decades and beat inflation. Adjusting for inflation the S&P averaged over 6% per annum from 1930 to 2020.

Bonds on average offer a lower return than stocks, but they can also regularly beat inflation. From June 2005 to June 2020 the US Aggregate Bond index tracking thousands of US bonds had annual returns of 4.47%.

This return would still have seen a modest increase in the purchasing power of investors’ money. Current and recent bond yields have been lower than historical averages but they are rising again as interest rates rise.

In conclusion, this is a very uncertain time for people and many will struggle. Keeping a strong eye on your monthly finances is key and, in many cases, we may have to do without some items that we might like to have.

For those with assets, inflation can be a good thing and for those with cash investing it wisely can help to inflation proof your wealth. As always seek advice from a good financial planner and invest in a well-diversified portfolio.

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