Inflation and why it affects us all

Posted By Robert On Friday, August 22nd, 2014 With 0 Comments

Whether you have an interest in Economics and/or investment, inflation affects you, in fact – inflation affects anyone who uses pound notes as a medium of exchange.

To start, we should define the term ‘ Inflation ‘ as: a general increase in prices and fall in the purchasing value of money. There are many causes of inflation and we shall explore some basic concepts here.

Fiat Money

We will explore:

  • Why inflation is essential for the modern economy
  • What happens when hyperinflation sets in
  • How inflation is calculated
  • In addition to how house and petrol prices can be a symptom of inflation

So we know that inflation is the general rise of prices within the economy, but why does this occur in the first place? Inflation has reared it’s ugly head for centuries and often by what is called “debasement of currencies”.

When trade was based upon exchange of Gold and Silver coins, governments would melt these coins down and add non precious metals in order to dilute the precious metal content of the coins. This would allow them to issue more coins into circulation for a very small price.

So how does this make prices rise?

If we consider the population of a whole country and double the money in people’s pockets, it is natural that they will want to use their increased spending power to buy more goods and services. Goods and services however, are in limited supply so there will be too much money chasing too few goods – and prices will rise.

Why do countries keep printing their own money if it devalues the current money supply?

Fed and Inflation

Great question! The simple answer is to keep the economy and business moving forward. If the government did not increase the money supply then ‘deflation‘ will occur and this will hurt business and the economy.

If there is less and less money in circulation then the prices of goods will start to fall. If the public realised that the price(s) was falling they may delay purchases and horde their money waiting for lower prices. This will cause a spiral of prices as businesses try to attract customers – leaving many businesses to become insolvent with consequential job losses.

The other reason is that nasty dirty little ‘D’ word!….Dandelion! no hang on, that’s not it… erm oh yeah! = Debt!

Those who paid attention to the news in late 2012 when it emerged that countries had huge deficits that several hinted at defaulting on, will know that debt is a huge factor here. If England owed one million pounds to France and inflation occurred at its targeted rate of ~2% per annum then the pounds paid to settle that loan would arguably have less “purchasing power” than when they was first loaned out by France.

If the UK borrowed one million pounds and deflation occurred, then that one million pounds is now far more valuable than when it was originally borrowed, making it much harder for the UK to afford it’s debt repayments. So deflation really does cause a burden on those who have debts.

How is inflation measured?

Inflation is measured by calculating the CPI (Consumer Prices Index) and RPI (Retail Prices Index). These indices may be used to calculate the percentage by which prices in general have risen over any given period and roughly speaking this is what is meant by inflation.

Hyper Inflation

The RPI is intended to reflect the average spending pattern of the great majority of private households (excludes pensioners and the high-income households). The CPI has a wider remit – it is intended to reflect the spending of all UK residents.

The calculations are performed by measuring the price increases of a wide range of basket of goods on a monthly basis. Inflation is as such calculated every month by the office for national statistics (ons), which looks at the changes in the price of 700 goods and services in 150 different areas across the uK.

This is known as the Basket of Goods and the subjects change with the times to reflect changes in spending activity. for example, tablet computers have been added to the basket in recent years, while the price of photo printing services is no longer considered.

There are two indexes that measure inflation:

  • Consumer Prices Index (CPI)
  • Retail Prices Index (RPI)

These are two baskets comprising different goods and services using different methods to calculate the rate. The main difference is that RPI includes housing costs, such as mortgage interest payments and council tax.   This means that inflation measured using CPI is lower than that determined by RPI. Items included in CPI that are not used to calculate RPI’s inflation figure include university fees and charges for financial services.

In the UK, the annual rate of inflation is the percentage increase in the value of the CPI (or the RPI) compared to one year earlier.

The RPI score can be used to calculate the ‘purchasing power of the pound’. The purchasing power of the pound measures how much a consumer can buy with a fixed amount of money at one point in time compared with another point in time.

To calculate the purchasing power of the pound we use the following:

(Value of RPI at date B / value of RPI at date A) x 100.

Starving Billionaire

The ons used RPI to calculate inflation until the conservative-led coalition Government switched to CPI. In april 2011, in what proved a controversial but profitable move. a high court challenge to the move by several trade unions was unsuccessful in stopping CPI from being used to determine the size of the state pension and other benefits the government pays. The switch saved £1.2 billion in the first year following the change.

Can we protect ourselves against the effects of inflation?

Inflation will affect us all, however there are ways to protect your wealth from being relinquished into the system. The most widely accepted method is arguably purchasing precious metals as an investment. Many buy Gold during times of high inflation, Zimbabwe was a recent classic case, their government debased their currency to such a degree that hyperinflation occurred, instantly zeros was added to their Dollar bills and Billionaires was created in a short space of time, however its no use being a billionaire if a loaf of bread cost 2 billion Zimbabwe Dollars!

Bearers of their dollar notes wanted to spend the money as quickly as they could due to fear that it would lose its value quickly and become more worthless before the bearer had a chance to spend it. When this occurs the population eventually ditch their countries currency and begin to trade in either another countries currency (such as US dollars)  or Gold and Silver.

However there is a much more efficient way of protecting from inflation. Those who use their savings to buy shares are effectively going to reap rewards of inflation. Inflation causes the price of goods to increase due to the pound/dollar/euro losing some of it’s value.

Therefore shares will increase in price too, if someone bought Tesco shares for 300p per share, inflation increases by ~2% per annum. Now Tesco pays a dividend of around 4.5%, which means that if you hold £1000 of Tesco shares, in one year you will receive £45 which is far more than the rate of inflation.

Additionally, Tesco’s profits will likely rise with inflation, leading to a higher valuation of Tesco’s underlying business which will have a positive effect on it’s share price.

A final word on inflation

Inflation is a great explanation as to why house prices tend to appreciate in price, the brick and mortar are not more valuable as the years go by – yet the price increases. The pound notes used to value that house are slowly losing their purchasing power, therefore it takes more pounds to buy the same house. Giving the artificial affect of the price rising.

The same can be said for petrol/oil prices, factors influencing oil prices can be quite complex but over time it can be claimed that the true “price rise” for fuel is often caused by the fact that it takes more of your devalued pounds to buy that gallon of oil than it did before. Additionally inflation means the cost of extracting and producing the oil also rises, which in turn is passed on to the consumer through means of price increase.

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