How Inflation Affects Your Savings and Investments

How Inflation Affects Your Savings and Investments

Inflation is a common word, and despite its frequent use, many people still do not understand it. Inflation is the increase in the price of goods and services in a particular economy. It is an increase in the cost of living in an area. It also shows how expensive goods and services have become over time. In essence, inflation is an obvious indicator of the decline of purchasing power.

To assess the impact of inflation, you should consider the costs of goods and services required for daily survival. Examples include transportation, food, health care, and electricity. Inflation affects different parts of an economy. Examples include the cost of living, worker incomes, savings, investments, etc.

Inflation has several effects on the economy of a growing nation like Nigeria. To claim to have experienced inflation, two conditions must be. First, the price rise must affect the economy’s entire range of products and services. A small price increase in a limited number of products or services is not inflation. Second, the price increase must also be constant to count as inflation. All price levels must be on the increase over a certain period.

Imported inflation is a factor causing inflation in a developing nation like Nigeria. Importation from countries where inflation is a problem causes this type of inflation. Nigeria’s monetary policies and current economic situation also cause a high inflation rate.

As was already mentioned, inflation has various effects on every economy. A consequence of inflation is a decline in the purchasing power of consumers. For salary earners, earnings do not go as far as they once did. In other words, most people’s salaries have not increased in line with the cost of goods and services. Workers suffer when their pay does not rise in tandem with the cost of goods. This is because they cannot afford the things they once could. If earnings increased later, inflation would have affected the cost of goods again.

What is Inflation?

As mentioned earlier, inflation is the increase in the price levels of an economy. It is the reduction of the purchasing power of consumers. As a result, each currency unit does not function as it once did. Money buys fewer goods and services as the general price level rises. Economies enjoy a small amount of inflation because of many high-profit investments. Yet, if it increases and spirals out of control, it can be destructive.

When inflation becomes unmanageable, it either turns into hyperinflation or stagflation. The affected economy’s currency degrades when there is a continuous inflation cycle. This causes hyperinflation, doing more harm than good to the economy. Conversely, stagflation occurs when unemployment rises while inflation stays high.

Measuring Inflation

Surveys are necessary to track the cost of a basket of products over time. These surveys help calculate the average cost of living in an inflation-affected economy. The Consumer Price Index (CPI) is the most used method of calculating inflation. It calculates for everyday products like transportation, food, and health care. The CPI calculates the percentage change in this basket’s price over time.

The consumer price index’s annual percentage change serves as a gauge of inflation. The CPI corrects inflation’s effects, including the value of salaries and price regulation. The consumer price index is a monthly or quarterly calculation in various nations. This makes it one of the most watched national economic indicators.

The wholesale price index (WPI) tracks changes in the cost of goods before they sell at retail as another indicator of inflation. Another tool for gauging inflation is the producer price index (PPI). It tracks the average shift in prices paid to domestic manufacturers for their goods. In essence, it is a measurement of inflation from the point of producers or service providers. It relies on several indices that track producer prices by sector and product class.

Causes of Economic Inflation

To understand inflation, you must remember that there are different causes. Primary causes include demand-pull inflation, cost-push inflation, and built-in inflation.

1. Demand-pull inflation is when the demand for goods and services exceeds the total supply. It is a rise in consumer demand without a corresponding rise in supply. By employing more, purchasing more raw materials, and increasing prices, company owners and organisations try to meet consumer needs. Thus, as a result of the extra funds used to try up the supply, the prices of products go up, which leads to inflation.

2. Cost-push inflation results from rising input costs like labor or raw materials. An indicator of this is a decline in product supply caused by inflation in production costs. Because the demand for the affected products has not increased, it causes inflation. When an economy is doing well, there is a labor shortage because of the low unemployment rate. As a result, businesses raise their pay to recruit workers, increasing production costs. A possibility of cost-pull inflation arises when this occurs.

3. When employees and wage earners call for a raise in pay, built-in inflation happens. This increase causes a commensurate rise in production costs. It also causes a rise in the cost of living and inflation. Employees demand salary increases due to continued inflation. This increases cost pressure on businesses and feeds a cycle of inflation. There must already be inflation in place for built-in inflation to occur. Business owners plan by increasing prices in response to their forecasts on inflation. Consumers also buy goods before prices go up to avoid price increases.

4. Devaluation is the lowering of the value of a country’s currency in a fixed-exchange-rate system. It is also another factor contributing to inflation. A country’s exports become cheaper due to the devaluation of its currency. This allows other nations to buy more for less. Additionally, the cost of importing goods or services increases for the affected country. Consumers would choose to buy domestic items due to the price increase of imported goods. Then, domestic product producers would raise their prices due to the increased demand. This starts a never-ending inflation cycle.

Other causes of inflation include an increase in wages, fiscal policies and regulations, an increase in money supply, etc.

How Does Inflation Affect Savings and Investments?

Consumer decisions, because of reduced purchasing power, result in lower consumption. Consumers suffer the economic volatility this causes. How much of your income you should save and invest depends on inflation. This is because inflation can impact your money in various ways.

First, inflation can make your money less valuable, affecting different savings and investments. Your savings will not have the same worth as when you deposited them. This is because inflation lowers purchasing power. In other words, even while you do not lose money, your net worth decreases because of inflation.

For instance, if inflation is 6%, you will need to save an extra 6% to ensure that your savings are adequate. Even if you are on a savings plan that earns you some interest over time, your purchasing power reduces. You will lose money if your savings do not increase at the same rate as inflation.

Making high-return investments is the best strategy to guard your assets against inflation. Even if you choose to invest your money, you should note that inflation also affects investments. In other words, inflation can affect future returns from investments. As such, it is something to consider before making investments.

Yet, how inflation affects various investments varies. It also sometimes works to the investment’s advantage. During inflation, investments with fixed long-term cash flows would lose purchasing power. Those with variable cash flows would prosper. Here are a few investment classes and how they are affected by inflation:

1. Fixed Income Investments

Investing in fixed income securities results in recurring dividends or interest payments. Investors make these kinds of investments to secure a steady income. Yet, their purchasing power decreases when inflation increases because the interest rate stays the same.

Take bonds, for instance. Bonds serve as fixed-income investments that offer lower risk and regular interest payouts. When inflation increases, bond returns are lower in real terms. For instance, if inflation is at 4% and a bond offers a 5% yield, the actual rate of return on the bond is 1%.

2. Stocks

Inflation has mixed effects on stocks. The performance of the company holding a stock will determine if inflation will hurt it. Large corporations that provide goods that people buy daily see their stock prices do well against inflation. For smaller businesses, inflation drives up the costs of wages and raw materials, lowering the value of their stocks because they don’t make any more money from sales.

Ways To Fight Inflation

As established, inflation results from an increase in the cost of production or consumer demand. However, it can prove very helpful to the affected economy if kept in check. To reduce the consequences of inflation, the government must install specific policies. Here are some of them:

1. Price Control

Price controls are price caps that the government imposes on a particular range of goods. They exist to manage the affordability of goods and services through economic intervention. They also reduce inflation by making goods more accessible to customers. Price controls affect more necessities like food and transportation. This plan restricts price increases and controls inflation.

2. Fiscal Policy

Fiscal policies help the government change taxation and spending levels to regulate the economy. Inflation occurs when the demand for goods and services outpaces the supply. As such, the government can combat inflation by enacting certain fiscal policies. This makes people cut down on spending, lowering demand and the availability of money.

3. Monetary Policy

The monetary policy, one of the most common methods for controlling inflation, seeks to reduce the amount of money available in an economy by raising interest rates because higher rates affect the cost of borrowing and make credit more expensive. They lower inflation levels and reduce the growth of the economy’s total demand and consumer spending.

The exchange rate, income, supply-side policies, targeting money supply, etc., are other measures the government can take to combat inflation.

Inflation-Proof Investments

As already mentioned, the only sure way to avoid the effects of inflation is to find the best savings and investment options. Although no investment comes without risks, some serve as a hedge against inflation. Here are a few of them:

1. Real Assets- Real Estate, Land, Natural Resources

Real assets are tangible possessions with inherent value derived from their features. These assets often do better against inflation than the majority of investing choices. There are various causes for this, but the main one is the profit of that tangible asset from inflation. In other words, when prices and inflation increase, so does the income from tangible assets.

Infrastructure and real estate are assets that grow with inflation and can act as havens from it. In an economy suffering inflation, assets like real estate tend to thrive. This is because rent increases with inflation. Also, the value of your property rises with inflation, and your assets’ debts get devalued. This devaluation is because of the general devaluation of the currency of the affected economy.

2. Leveraged Loans

A leveraged loan is given to businesses with high debt levels or bad credit scores for various reasons, such as funding projects. These loans often span over five to seven years. Assets belonging to the borrower serve as collateral. Leveraged loan investments may provide inflation protection. Interest rates on leveraged loans shift upward in tandem with consumer interests. As such, these loans have a higher ability to hold their value than other fixed-income assets.

3. Equities

Equities are one of the potential havens from inflation. This is because corporate profits ought to increase at a similar pace to inflation. This increase would raise share prices for consumer and producer goods. But not all equities do well in times of rising inflation. Bigger companies generate higher returns, compared to smaller ones. This is because of the established market position and many revenue sources.

4. Commodities

Sectors like commodities usually produce superior returns when inflation is on the rise. In times of economic inflation, the prices of commodities like raw materials and agricultural products rise in tandem with their final goods. Because their prices rise with inflation, commodities serve as a hedge against inflation. A typical illustration is how inflation increases the price of crude oil, causing an increase in gas and transportation. The trading of commodities futures or producer shares is available to investors.

Conclusion

In a nutshell, inflation is an increase in a country’s prices for goods and services. It also affects the purchasing power of its citizens. Several factors contribute to inflation. The three main ones are built-in inflation, cost-push, and demand-pull inflation. Measuring inflation is essential, and there are several tools for it. The most used include the Consumer Price Index, Wholesale Price Index, and Producer Price Index.

Inflation can be positive or negative depending on the viewpoint and pace of change. Still, it harms savings since it lowers purchasing power. This means your money is no longer worth what it did when you deposited it. Because they represent future cash flows, investments like bonds suffer during inflation. Real estate, leveraged loans, shares, and commodities, are investments inflation does not affect. Policies such as price regulation, fiscal policy, and monetary policy reduce the effects of inflation on an economy.