Inflation: What it means and how it impacts your wealth

Inflation refers to the consistent increase in the average price of goods and services over a given period.

If your dollar doesn't go as far as it did yesterday, that's inflation. However, it's not quite that simple. A little bit of inflation is fine. In fact, that can be seen as a sign of a healthy economy. Nevertheless, it reduces the value of money over time. If inflation is allowed to rise dramatically, it can be quite destructive. In recent years, a number of nations have faced economic collapse due to aggressive inflation. 

Inflation vs Hyperinflation vs Stagflation

Inflation is an economic phenomenon that occurs when the general level of prices for goods and services rises. It is usually measured by the Consumer Price Index (CPI). Inflation can be caused by a variety of factors, including an increase in the money supply, a decrease in the purchasing power of money, increased demand for goods and services, or a combination of these and other factors. Inflation erodes the purchasing power of money, meaning that individuals and institutions must spend more money to buy the same amount of goods and services.

When inflation gets out of control and keeps rising rapidly, it leads to hyperinflation or stagflation, which hampers economic growth and purchasing power.

Hyperinflation:  This is simply a very high and rapid rise in inflation. Economists say hyperinflation is a scenario where prices rise by at least 50% each month. While this is rare, it has happened during times of civil unrest. During hyperinflation, currency loses its value quickly, which can lead to widespread suffering. Some examples of nations that have experienced hyperinflation in the past include Zimbabwe, Venezuela, Argentina, and Brazil.

Stagflation: This refers to an economic condition when a country's economy stops growing while unemployment goes up and inflation remains high. In general, when unemployment is on the rise, people cut down their spending, leading to a decrease in consumer demand, which in turn impacts the pricing. As a result, eventually, prices are lowered to adjust consumers’ purchasing power. Stagflation challenges this economic theory.  In a nutshell, stagflation is a combination of three negative things: stagnant economic growth, high unemployment and high inflation. 

In Canada, as of December 2022, inflation rate stands at 6.3%. This is higher than the long-term average of 3.14%. The Bank of Canada is responsible for controlling inflation. It aims to keep inflation between the target range of 1 to 3 percent to maintain its mandate of stable prices and maximum employment, which is required for healthy economic growth. In order to achieve this target, the Bank of Canada raises or lowers its policy interest rate as needed. It usually takes six to eight quarters for such policy actions to have an impact on the economy and inflation. 

Here's how high inflation can impact your ability to generate wealth:

Lower purchasing power: In the short term, rising prices may imply rapid economic growth and may cause an increase in demand. This is because people will try and buy more than they need today to avoid tomorrow's higher prices. When this happens, suppliers can't keep up and neither can the value of money. The outcome is inevitable – nearly everything gets priced out of most people's reach, thereby increasing the cost of living.

Variable interest rates: Inflation and variable interest rates have a strong correlation.

Variable interest rates are interest rates that change over time in response to changes in the market. When inflation increases, variable interest rates will usually increase as well. This is because when inflation rises, the cost of borrowing money increases, and lenders will need to charge higher interest rates in order to cover the cost. Variable interest rates can be beneficial if inflation is low, as borrowers will be able to take advantage of lower rates. However, if inflation rises, borrowers may find it difficult to keep up with the higher payments.

Eventually, with a growing interest rate scenario, people may start to save more of their money and companies may try to curtail their prices to uplift sales. Over time, this reduces inflation and rebalances the economy.

Fixed income earners: If inflation slashes purchasing power with every passing year, it's almost impossible to maintain your standard of living. This is especially true if you have a fixed income. As the value of money goes down, you may have to start cutting back on discretionary spending.

Increase in cost of production: This is known as cost-push inflation. Factors such as an increase in the wages of workers and the cost of raw materials can result in higher production costs. As these costs increase, so do prices. This can cause a drop in supply while demand remains unchanged, leading to shortages and additional price hikes.

Increase in money supply: Inflation is caused when the money supply of an economy grows faster than the production of goods and services. In simpler terms, if people are willing to pay more for goods and services, it means that the supply of money has grown. When this happens, the value of money goes down and purchasing power drops.

Rising demand for goods and services: This is demand-pull inflation, and it is caused by a surge in demand across an economy. As the demand for a particular product or service increases, supply decreases. This results in higher prices.

Inflation expectations: Inflation that is caused by people believing that prices will rise is known as built-in inflation. This has a cascading effect.  Workers demand higher wages which can lead to a rise in production costs. It can also increase disposable income which in turn, increases demand. This eventually leads to a wage-price spiral, which is an economic term used to describe a situation of price increases as a result of increasing wages.

Investment choices:  In an ideal state, your investments should be earning more than the rate of inflation and that’s the goal of most investors. Choosing investments carefully, as per your risk profile and at a rate to beat inflation, may prove to be helpful in protecting your wealth. You may have also heard the phrase “don’t put all eggs in the same basket”. This may also apply in this scenario where portfolio diversification can be a helpful strategy. In addition, many investors also consider investing in assets that are not affected by inflation, such as gold and commodities, to protect their wealth. 

Plan your spending: As the cost of living goes up and you get less value for your money, it may be helpful to identify ways to reduce your spending. This is important to ensure you are not eating into your reserve funds and keeping your investments intact for long-term gain. 

Review your debt situation: Inflation is often accompanied by a rise in interest rates, making any debt you carry more expensive. This can also mean that it will take longer to pay off everything and be debt-free.

Additionally, it is important to stay informed of the current economic climate and any changes that may affect inflation. 

Putting together a diversified portfolio based on risk tolerance can be a good defense against inflation. If you have a sound investment plan, inflation cannot stop you from achieving your goals.