We’ve all heard the word ‘Inflation’, but what exactly does it mean and why should you care?
Well, in context to the image above, it’s not nearly as much fun. In simple terms, inflation, normally measured as a percentage, is the rate at which prices of a specific product or sector increases. For instance, last year, a Pepsi cost $1.00, while this year that same Pepsi costs $1.10. The inflation was $0.10 over the last year for a percentage of 10% ($0.10 / $1.00). Simple, right!
Now, inflation is generally measured across a broader spectrum to include anything from your day to day grocery prices to fuel prices to car prices and even include house prices. This will give you an average inflation rate for, in most cases, a country. The inflation rate for the US in the last 4 years was as follows:
- 2020: 1.4%
- 2021: 7%
- 2022: 6.4%
- 2023: 4.9%
Why does it matter?
Let’s go back to the Pepsi example. Let’s simplify it and say you have $100 of disposable income per month and your only joy in life is to drink as much Pepsi as you can. The year is 2020, and Pepsi costs $1.00 per bottle, meaning you can drink 100 bottles of Pepsi per month with your $100.
Come 2021, and inflation is up 7% and your Pepsi now costs $1.07. Your disposable income is still at $100, but now you can only get 93 bottles of Pepsi for your $100.
2022 hits and inflation is up another 6.4%, pushing the price of your bottle of Pepsi up to $1,14. You still only have $100 of disposable income to spend, which means you can now get only 87 bottles of Pepsi per month. You get the idea.
So what is really going on here? The Purchasing Power of your money has become less, you can get less for your $100 now than you could 3 years ago. In short, inflation made you poorer.
The advantages of inflation
Wait, there are advantages? Yes! Well, sort of. As inflation is measured across a broad spectrum, including house prices, that means that house prices also increase. And the reason house prices increases is because with inflation, building prices increase, which means to build a new house costs more in 2022 than it did in 2021. Now, with houses being long-term investments rather than short term liabilities, your house will increase in value to keep up with the rising prices of new houses, not exactly, but fairly close.
For instance, let’s say you bought a home for $100,000 in 2013 and the year is now 2023 where it costs $250,000 to build a home of similar size and shape, you can expect your house’s value to have increased to $230,000 at the very least, considering you’ve maintained it well. That means if you owned property, and lots of it, inflation has helped to make you rich!
The other advantage of inflation is that erodes the real value of your debt. Let’s say you bought a $100,000 house in 2020 on a 100% mortgage. Inflation for 2021 was 7%, that means that $100,000 debt you owe, while still $100,000, in real terms would only be the equivalent of $93,458 worth of debt acquired in 2020.
As time goes on and inflation keeps ticking up, that debt will start to become all the more insignificant. If this seems a little bit confusing, that’s because it is. But think of it this way, 10 years ago you might have paid $0.50 for a bottle of soda. At the time, that seemed a lot, but looking back to it now, that $0.50 sounds cheap compared to what that same bottle of soda costs today. That, is inflation eroding the value of money, as well as debt.
Inflation vs earnings
The real measure to if you’re better or worse off than the year before is by how much your income or investment returns have outperformed or underperformed inflation. It’s as simple as that measure.
Let’s say your annual inflation for the last year was 7% but your net income has gone up 10%, income-wise, you are 3% better off that you were the year before (10% – 7%). Simple. If your net income was flat, perhaps because the company you work for couldn’t afford raises the last year while inflation was 7%, that means you are 7% worse off than you were the year before. It’s literally the equivalent to your company decreasing your paycheck by 7% if prices remained flat.
Your wealth is primarily built by two things, smart investments, as explained a little by this article https://www.embracetheunknown.com/salaries-pay-bills-property-builds-wealth-investing-101, and the outperformance of your income vs the rise of inflation.
So what drives inflation? Why do prices keep on going up?
Well, a lot of things. For one, the general workforce requesting raises to their annual paychecks while the work output remains the same (however, this is normally only to keep up with inflation. What a death loop!). An increase in earnings from other sources such as investments, meaning people making money from their stock market investments now have more disposable income to spend, so they spend more, increasing demand which allows suppliers and retailers to increase prices. Interest rates controlled by central banks (their only tool to combat inflation, ironically is by raising interest rates which in turn, raises inflation. Idiots.), but the biggest driver of them all – the fuel price!
Everything you and I consume, from our food to the bricks our houses are built with to the clothes we wear, all of it needs to be transported, not to mention ourselves, we need to get to work and go out and have some fun, we need fuel for everything! So if we see a massive increase in oil prices, like what happened when Russia invaded Ukraine, going from their lows of $20/barrel to a high of $126/barrel, that is a massive driver of inflation.
At the time of writing this article, oil prices have fortunately decreased to to their medium price of around $70/barrel, a happy place for both producers and consumers, but what happens in turn is the politicians now know you are use to paying more for your fuel, so when the input price of fuel (mainly driven by the cost of oil) slowly starts going down, they increase taxes on fuel to fill their spending gaps, meaning as the consumer, we wont get the full benefit of oil prices going down, and all of this just adds to inflation.
Yes, we’re done!
I hope this short overview wasn’t too boring, and that it gave you some new perspective on inflation.