“Inflation is caused by too much money chasing after too few goods” – Milton Friedman
The spate of inflation wreaking havoc on the global economy is causing a cost-of-living crisis across Australian, UK, U.S. and EU markets. Central banks in each of these developed regions have been raising cash rates to fight the rising cost of living, and as a result interest rates have risen substantially.
Just as interest rates determine the cost of debt, that is how much you will pay to borrow money, inflation rates reflect how much more things cost from one year to the next.
Inflation has been a hot topic in the news lately, so if you’re wondering what inflation is or how it can reduce the “real value” of your investments, this article is for you.
What is inflation and how is it calculated?
Inflation is, simply put, how much the cost of goods and services have “inflated” over the past twelve months.
Expressed as a percentage, the inflation rate is the average annual rate of change of consumer prices, tracked by the Australian Bureau of Statistics’ (ABS) Consumer Price Index (CPI).
In Australia, CPI considers thousands of items in almost 100 categories including housing, health, education and recreation. As of March 2023, the average cost of consumer goods and services has increased by 7%.
However, there is a caveat. Inflation is measured as a weighted average, so some goods and services have increased by more, and some by less, than the 7% average inflation rate. Housing costs, for example, have increased by 9.8%, whilst Recreation and Food have risen by 8.6% and 8% respectively.
Does inflation affect the real value of money?
The reason why inflation is such an important concept to understand when planning your investments is because it can change the ‘real value’ of money.
Think about it this way, every year as prices increase your money will buy you less.
For example, taking the current annual rate of inflation, goods and services have increased by 7% since last year. So, what cost $100 last year will now cost around $107, meaning the value of your money (your purchasing power) has decreased by $7.
This gets even more complex when it comes to investments, as that $7 can turn into thousands, or even tens of thousands in lost value.
According to the RBA’s Inflation Calculator, a $100 basket of goods in 1966 would be worth $1,475 in 2022, and a $100 basket in 2000 would cost around $178 in 2022.
That means in just two decades, the cost of living has almost doubled.
How does inflation impact the value of my investment?
When it comes to investing, it’s important to try and retain the current value of your money and investments, despite the rising cost of living (inflation).
Seven dollars might not add much to a $100 basket, but when you calculate a loss of 7% on investments of $500,000, $1,000,000 or more? That is far greater.
Let’s say you put $500,000 cash aside in 2022, perhaps you hid it under your mattress.
In 2023, the $500,000 is still technically there, and the same amount of money.
However, due to inflation, it won’t buy you as much. Everything has gotten 7% more expensive.
If you decide you want to purchase $500,000 worth of goods and services, you’ll need another $35,000 to cover the cost. Your half a million dollars now has a ‘real value’ of just $465,000.
Now, let’s imagine in 2022 you put that $500,000 into a term deposit, rather than under your mattress.
This term deposit was offering 4% interest, locked in over three years.
From 2022 to 2023, your money will have increased your $500,000 in value by 4% through the interest earned on your term deposit account.
However, there is still a loss of 3%, which means a substantial amount of “real value” ($15,000) has been lost in the first year.
As the years go by, and inflation compounds, the calculations become more complex, as is the ability to determine the exact “real value” of money that has been lost to inflation.
This is why Australian Bond Exchange CEO Bradley McCosker says, “Rational investors should expect a return on their investment greater than inflation.”
If the inflation rate is higher than your annual return, investors can end up losing thousands, or even tens of thousands of dollars, in real purchasing power.
Australian Bond Exchange (ABE) has a range of fixed income products and investments offering close to or above the current inflation rate. If you’d like to chat about how to get a return higher than inflation, or about alternative products like inflation-linked bonds, get in touch with an investment adviser.
Does every country measure inflation in the same way?
How various regions determine the rate of inflation varies, as is the way they report on them.
For example, Australia uses the quarterly CPI data as the main indicator, the US uses the CPI monthly data to indicate inflation, and in the Euro area, the HICP (Harmonised Index of Consumer Prices) is used.
| Inflation Indicator |
Australia | Consumer Price Index (Quarterly Release) from the Australian Bureau of Statistics (ABS) Percentage Change from 12 months earlier |
United States | Consumer Price Index (Monthly Release) – from the US Bureau of Labor Statistics (UBLS) Percentage Change from 12 months earlier |
United Kingdom | Consumer Price Index + Housing (CPIH) and Consumer Price Index (CPI) (Monthly Release) – Percentage Change from 12 months earlier |
European Union | Harmonised Consumer Price Index (Monthly Release) – Percentage Change from 12 months earlier |
In the UK, it gets even more complex, with three main indicators; RPI, CPI and CPIH. RPI stands for Retail Prices Index, and the two Consumer Price Indicators are CPIH (Consumer Price Index + Housing Costs) and CPI (Consumer Price Index excluding housing costs).
According to the Office for National Statistics, the UK treats CPIH as the main indicator of inflation, but the CPI indicator (excluding housing) is still the figure touted by journalists when referring to UK inflation.
Financial markets in themselves are quite complex and subjective in nature, so it’s always best to check consult a professional financial adviser to get insight on how the current inflation rate will impact the value of your investments.
Australian Bond Exchange (ABE) has a range of fixed income products and investments offering close to or above the current inflation rate. If you’d like to chat about how to get a return higher than inflation, or about alternative products like inflation-linked bonds, get in touch with an investment adviser.
Disclaimer: This information has been prepared by Australian Bond Exchange Pty. Ltd (ABN 73 605 038 935, AFSL 484453) is of a general nature only. It has been prepared without taking into account your particular financial needs, circumstances and objectives. No representation or warranty is made as to the accuracy, completeness or reliability of any estimates, opinions, conclusions or other information contained in the content. The content may contain certain forward-looking statements. Forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors, many of which are beyond our control. You should not place reliance on forward-looking statements. To the maximum extent permitted by law, Australian Bond Exchange Pty. Ltd. disclaims all liability and responsibility for any direct or indirect loss or damage that may be suffered as a result of relying on anything in this content including any forward-looking statements. Past performance is not an indication of future performance.