Anyone who turns on the news occasionally will know that the word ‘inflation’ crops up quite frequently. But what does it actually mean and why should we be bothered about what’s gone up and what’s come down?
Generally speaking, inflation refers to a sustained increase in the price level of goods and services, resulting in a single unit of currency being worth less today than it was a year ago. Inflation as a figure is quoted in percent, so if someone says “inflation is expected to be at 5%”, what that actually means is that something that cost you R1.00 today, is expected to cost you R1.05 next year.
For millennials – sometimes said to be the most nostalgic generation – an example of inflation that gets their attention is the price increases of their childhood favourite bubblegum, Chappies.
The iconic multi-coloured South African sweets with the “Did You Know” facts printed on the inside of each wrapper have been around for over 70 years, and were sold at just 1c each when they were created in the late 1940s.
Nowadays, a single square of Chappies costs around 50c – that’s 50 times more than it was originally, which means the inflation rate for Chappies over the past 70 years has been a whopping 5000%! Of course, the price of Chappies did not surge from 1c to 50c overnight, but inflation each year gradually brought it up to where it is today.
So in other words, while R1.00 could have bought 100 Chappies back in the early 1940s, the same R1.00 can only buy two squares of Chappies today, showing how the Rand has lost purchasing power over time due to inflation. Time moves on and inflation is something we just have to get used to.
If we step back from the Chappies example and think about the economy as a whole, you might be wondering how the government measures inflation overall? The government measures the overall change in prices of ALL goods by using something called the “Consumer Prices Index”.
How does the government measure inflation using the Consumer Prices Index (CPI)?
In the same way that people observe the changes in Chappies prices by comparing one year with another, the government could do the same with all goods and services and use the average as the economy’s inflation figure.
In reality, they do not use this method for two very good reasons:
- It would take forever.
- Using ALL the goods and services and averaging them would make the measure irrelevant, because no single household buys every good or service available to them in an economy – it would be unrepresentative!
Instead various other measures have been constructed in an effort to give a more useful measure for inflation.
The Consumer Prices Index is based on something called a “representative basket of goods” (think of it as a really big imaginary shopping basket).
This basket of goods holds a collection of the most commonly-bought items by households each year – roughly 700 goods and services. Importantly the basket is not fixed. Instead, the basket changes slightly each year to take into account changes in what we are buying.
Bread, milk and train fares are some of the items included. Each are weighted to reflect their varying importance in a typical household budget.
Finally, in order to work out the inflation level, the change in the total price of this “representative basket” from one year to the next is calculated and this change gives us our inflation figure. Mind you, the baskets of the various households in South Africa can and do vary from this typical basket and so the actual inflation a single household experiences will likely vary from the official Consumer Price Index measure and from other households. The principle still remains though.
I know price rises sound worrying but inflation is not a bad thing.
Inflation is necessary to sustain a stable, growing economy. Businesses, for instance, can’t maintain and grow profits without increasing prices. Equally though, if prices rise too quickly, consumers may no longer be able to afford to spend and there may need to be sharp interest rate rises to bring inflation back under control. This can then choke off economic activity. So the government sees anything between 3% – 6% target as a healthy, balanced level.’
Why does inflation matter?
The predicted level of inflation helps give us an idea of how our economy is doing (economists use it as a thermometer to check an economy’s temperature), and also lets us know what price changes we can expect to see – normally a small increase.
As spenders it is also key for us to remember that inflation is closely linked to our income. If a Chappies is going to cost us 4.5% more in 2020 than it does today, but our income also increases by 4.5%, then next year the Chappies won’t actually cost us any more than it did today.
Inflation alone is not the be all and end all. It is also important to think about how inflation changes in line with your personal income. This will help you understand the effect it will have on your spending power and (importantly!) how many Chappies you can buy.
The eroding power of inflation on cash is one of the most compelling reasons we believe you should seriously consider investing in assets that have the potential to return more than the rate of inflation.
The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested.
By Kondi Nkosi, South Africa Country head at global asset manager, Schroders.