A Guide To Inflation

02 Feb 2024

These days, between the energy crisis, the increase in the cost of living, and the price of your supermarket shop always on the rise, it seems like everything is getting more and more expensive. Even if you’re being frugal with your spending, the inflation rate can make it feel like your money is worth less and less.

And it doesn’t seem like the prices will go down anytime soon.

But what exactly is inflation?

What is inflation?

Inflation is the rate at which the prices of goods and services in an economy increase over time.

It’s usually measured by how much the cost of a basket of everyday goods and services (such as food, clothes, and transportation) has increased over a period of time, typically a year.

When talking about inflation, we’re always referencing the market as a whole, not just individual items or regions.

So even if the price of milk went up, or rent in your town is through the roof, if the prices of other things stayed the same or even decreased, that’s not inflation.

How can inflation affect your cost of living?

Inflation can have a significant impact on your cost of living. If the prices of the goods and services you need to live (such as food, housing, and healthcare) go up faster than your income, then it becomes more challenging to maintain your standard of living.

That’s why, when the inflation rate is high, wages also tend to increase to keep up with the rising prices. The problem is that it doesn’t always happen, or there’s a risk that there will be a delay between when prices go up and when wages adjust.

How is inflation measured?

There are a few different ways to measure inflation, and the most common methods are the Consumer Price Index (CPI), or the CPIH, which also includes housing costs.

The CPI is calculated by taking a basket of common goods and services intended for household consumption and measuring how market prices have changed over time.

There are around 700 items included in the CPI.

The calculation of the CPI takes into account both government-charged user fees, such as car registration fees and taxes that directly affect the pricing of the items, such as sales tax or VAT.

It doesn’t include any taxes not directly linked to purchases, such as income tax, or investments, as they’re not part of standard day-to-day consumption.

What are the causes of inflation?

There are several factors that can cause inflation, although there’s often a combination of them.

Here are some common causes of inflation:

  • Cost-push inflation. This happens when the prices of raw materials or services for manufacturers increase, including the cost of wages and benefits for workers. They then pass the increased costs on to consumers through higher prices for goods and services.
  • Demand-pull inflation. This occurs when more people chase after fewer goods and services, resulting in a bidding up of prices. It can be caused by population growth or an increase in consumer confidence (and spending).
  • Fiscal policy. When the government spends more than it takes in through taxes and borrows money to make the difference, it can cause inflation if the government prints more money to cover the debt. This, in turn, devalues the currency and leads to inflation because your money is literally worth less than before.

Why should you care about inflation?

To a certain extent, inflation is an indicator of a healthy economy.

It usually means that people are employed and have money to spend, so the economy is growing.

While a little inflation is normal and even necessary in an economy, too much inflation can be a bad thing. If prices rise too quickly, it can lead to economic instability and even recession.

And it’s not just an abstract concept; inflation can have a tangible impact on your life.

On an individual level, when prices go up, your money doesn’t go as far, which means you have to either cut back on your spending or find ways to make more money.

If you’re on a fixed income, such as Social Security, your benefits or pension may not keep up with the rising cost of living. And if you’re trying to save for retirement, inflation can eat away at the value of your savings.

What you should be doing about it

Inflation is a reality that we all have to deal with, and there’s not much we can do to stop it.

But there are ways to protect yourself from the effects of inflation.

  • Inflation-proof assets. One way is to invest in assets that tend to go up in value when inflation is high, such as real estate or commodities. Gold is often seen as a good hedge against inflation because it usually goes up when the prices of other things rise.
  • Diversify. Another way is to ensure you have a diversified portfolio that includes investments that can do well in different economic conditions. For example, if you have investments in both stocks and bonds, even if inflation is high and stock prices are down, your bond investments may do well.
  • Increase your income. You can also try to increase your income by getting a raise at work, finding a higher-paying job, or starting a side hustle.
  • Cut your costs. One of the best ways to protect yourself from inflation is simply to buy less. By cutting back on your spending, you can ensure that your budget aligns with the rising cost of living.

While there’s no way to completely protect yourself from inflation, by being aware of its effects on your life and taking steps to mitigate those effects, you can help keep your cost of living under control.

Inflation is a fact of life, but it doesn’t have to be a roadblock to your financial success.

One important thing to remember about inflation is that it doesn’t last forever. Like everything in the economy, inflation tends to be cyclical, meaning there will be periods of high inflation followed by low inflation (or even deflation).

So even if prices are rising now, don’t despair. And most importantly, don’t make emotional investment decisions about your finances based on rising inflation today. When investing, your strategy should ideally be based on your long-term goals, not on short-term economic changes.