Inflation is an economic phenomenon that influences the prices we pay for goods and services on a daily basis. It has a big influence on our finances, reducing our purchasing power. As prices rise, we will be able to buy fewer products for the same amount of money.
The impact of inflation extends beyond just consumer goods and services. It also affects the broader economy, including wages, investments, and economic growth. For instance, when inflation rises, workers may demand higher wages to maintain their standard of living, which can lead to a wage-price spiral. This cycle can potentially exacerbate inflationary pressures, making it crucial for policymakers to carefully monitor and manage inflation rates.
While it is common knowledge that inflation causes increased costs, additional details of how inflation might effect our finances are sometimes overlooked. Understanding these factors of inflation can allow you to develop more realistic budgets.
One often overlooked aspect of inflation is its effect on savings and investments. As the purchasing power of money decreases over time due to inflation, the real value of savings can erode if the interest rate on savings accounts doesn't keep pace with inflation. This phenomenon, known as negative real interest rates, can significantly impact long-term financial planning, especially for retirees or those saving for major life events.
Here are three important characteristics of inflation that, while not widely mentioned, are critical for sound financial planning.
Inflation's compounding effect
One critical characteristic of inflation that frequently misses our notice is its compounding nature. If inflation causes price increases in a given year, the higher prices serve as the baseline for the following year's inflation. This compounding effect implies that prices will continue to rise (unless the economy enters a recession, resulting in deflation).
Assume that inflation averages 3% each year. If you regularly spend RM1,000 per month on food, your monthly spending will rise to RM1,030 in the first year. In the second year, inflation is estimated using the raised spending (RM1,030) after the 3% rise, rather than the original spending (RM1,000).
So, in the second year, your grocery spending will rise from RM1,030 to RM1,060.90.
Over time, this compounding factor could result in a significant increase in the overall cost of living. If you don't consider the compounding effect, you may encounter financial difficulties.
Inflation impacts everyone differently.
While inflation is frequently discussed as a broad economic issue, its consequences are deeply personal and closely tied to individual spending habits.
Inflation is measured using the Consumer Price Index, which calculates the average change in prices across a set basket of goods and services used by households.
However, because this basket does not reflect the specific mix of products and services that you use as a customer, it will not correctly reflect your purchasing habits.
For example, if healthcare accounts for a large amount of your budget, you should consider the typical rate of medical inflation. This rate may differ from the rate of general inflation.
To highlight this argument, Malaysia's average annual inflation rate last year was 2.5%, whereas medical costs are expected to climb by 14.2% per year. That's a significant difference. So, budgeting for a 2.5% rise will not be enough to meet all of your medical demands.
To properly modify your budget, examine your spending habits and identify areas that are more sensitive to inflation. In essence, personalising your approach to inflation guarantees that you are prepared for any price rises that occur.
It's worth noting that inflation can also have varying impacts across different demographic groups. For instance, retirees living on fixed incomes may be more vulnerable to inflation as their purchasing power diminishes over time. Similarly, younger generations facing rising education and housing costs may experience inflation differently than older generations. Understanding these demographic differences is crucial for policymakers and individuals alike when addressing the challenges posed by inflation.
High inflation leads to higher interest rates.
High inflation is expected to lead central banks to hike interest rates. As a result, borrowers may have to pay greater interest on their loans.
Individuals with variable-rate loans or those seeking new loans should budget for future interest rate increases.
The relationship between inflation and interest rates also has implications for the housing market. When interest rates rise in response to high inflation, mortgage rates typically follow suit. This can make homeownership more expensive and potentially cool down a hot real estate market. Conversely, periods of low inflation and low interest rates can stimulate housing demand. These dynamics highlight the far-reaching effects of inflation on various sectors of the economy and underscore the importance of considering inflation in long-term financial planning.
Inflation is a complex economic force, and understanding its complexities is essential for sound financial planning. Recognizing the compounding nature of inflation, personalizing its influence on your budget, and preparing for prospective interest rate hikes will help you navigate the hurdles offered by rising prices and protect your financial well-being.
