The Impact of Inflation on Your Money
Inflation is defined as ‘a general increase in prices and fall in the purchasing value of money’. Simply put, €1.00 today will buy you more than €1.00 will in two years’ time.
For example, it is quite possible that you can buy a can of soft drink currently in your local shop for €1.00. Now imagine over the next year that inflation is 2%. You can expect to pay €1.02 in a year’s time for a can of soft drink.
That means, if the increase in your income doesn’t keep up with inflation, you won’t be able to buy as many cans of soft drink in a year’s time as you can today.
Why does inflation occur?
Inflation comes about when the demand for goods and services increases in an economy. When the money supply in an economy grows, there will be more demand for goods and services from consumers. As people are willing to pay more for goods, sellers increase their prices and inflation occurs.
You might see this concept referred to in places as “Purchasing Power”. Purchasing power is the amount of products and services that you can buy with €1.00. Consumer Price Index You might also be familiar with the Consumer Price Index (CPI) which is measured in Ireland by the Central Statistics Office. CPI is the official measure of inflation and can be used as a measure of your purchasing power. Your purchasing power increases when CPI decreases and decreases when CPI increases.
The graph below shows how prices have increased since 1975 in Ireland as indicated by CPI. The graph shows that if €100 was used to purchase a basket of products and services in 1975 then the equivalent products and services would cost €674.20 in 2016.
The above illustration is based on the annual percentage change in the Consumer Price Index. Source: Statistics from the Irish Central Statistics Office, 07 April 2017.
Consider the impact of inflation when choosing fixed return investments
Inflation diminishes your purchasing power. If a bank offered to pay you 5% interest today for putting €100 into a deposit account for a year. In one years’ time you would collect €105.
However, what if inflation for that year was 2%? Your real rate of return would be 3% (5% - 2%), so your €105would in fact only be worth €103 in “today’s money”.
The real rate of return is important because it gives the return on an investment after inflation is taken out. The real rate of return gives you a better view of an investment’s value in terms of your purchasing power. A return of 4% may look like a good return; however, if inflation is 5%, your investment is in fact losing money.
With this example in mind, investors should try protect their purchasing power by choosing investment products with returns that are equal to or greater than inflation. Investment returns can fluctuate more in the short-term whereas long-term returns tend to be more stable. Unless guaranteed, you could lose some or all of the money you invest. However, if you’re willing to sacrifice access to your money for a few years and accept some risk your reward will hopefully be worth the wait.
Interested in reading more?
If you found this article helpful, why don’t you read ‘Fund Types and Investment Styles’ – a practical guide to help you understand the difference between active vs passive investing, balanced funds vs multi-asset funds and more.