What is inflation?

What is inflation?

Inflation refers to the rise in prices of goods and services in an economy.
It is measured as the rate of change in those prices over time. For example, if a product that cost $100 last year now costs $103, the inflation rate would be 3%. 

As prices increase due to inflation, the purchasing power of a currency (such as the Australian dollar) decreases. This means you’ll need more funds to purchase the same amount of goods or services. 

Inflation is influenced by a number of factors and doesn't impact all goods and services the same way. Here we take a look at how inflation is measured, what causes it, and the impact it has on investors. 

Image source: Getty Images

How is inflation measured? 

Inflation is typically measured broadly, indicating the overall increase in prices in an economy or increased cost of living in a country. 

But it can be measured more narrowly, by reference to specific goods or services. Rates of inflation may differ across products and services, such as groceries, petrol, clothing, or transport. Whatever the underlying product or service, inflation is how much more expensive that product or service has become over the period measured. 

In Australia, the most well-known measure of inflation is the Consumer Price Index (CPI). It measures the percentage change in the price of a basket of goods and services consumed by households. 

If a certain good or service experiences a significant change in price (either up or down) this can impact the overall inflation rate. For example, if petrol prices increase by 20%, this can push the overall inflation rate higher because petrol is a widely-used good. 

As a general rule, when the economy is healthy, a moderate single digit rate of inflation should be expected. 

The Reserve Bank of Australia (RBA) targets an inflation rate of 2-3% based on the CPI. When inflation moves outside this bracket, the RBA may use monetary policy (like increasing or decreasing interest rates) to try to push inflation back within the range. 

Who reports inflation figures? 

The Australian Bureau of Statistics (ABS) reports the CPI rate on a quarterly basis. It reports the quarterly change and calculates an annual rate for the preceding 12 months.

The annual CPI rate in Australia in 2021 was 3.5%.

The ABS measures the CPI by collecting the prices for thousands of items. It then calculates the change in price for each item and aggregates the data to work out the CPI rate. 

What causes inflation? 

Inflation can be caused by the demand effect or the supply effect

With the demand effect, an increase of money in the economy increases overall demand for products more rapidly than production capacity. This leads to price rises. 

With the supply effect (also known as the ‘cost effect’ or ‘push effect’), there is an increase in prices working their way up through the production process. 

If the cost of raw materials or other inputs increases, this will cause the overall price of goods and services to rise. The supply effect is demonstrated when natural disasters such as floods result in an increase in the cost of goods sourced from the impacted region. 

Inflation can also be built in and related to expectations. People expect inflation to continue to increase prices, just as workers continue to request pay raises. 

This is the price-wage spiral. Rising wages create an increase in disposable income, which then increases demand for products and services, which in turn causes prices to rise. 

The rise in prices increases demand for higher wages, leading to higher production costs. This puts more pressure on prices, creating a spiralling effect. 

How does inflation impact shares? 

Inflation has an impact on the real returns that ASX investors receive from shares. Say you invest $100 today and your investment is worth $105 in a year (a 5% return). If inflation is  6%, your money will buy you fewer goods than it could a year ago. 

Most investors are looking for returns that outpace inflation so they can grow the real value of their investments. The aim is to guard portfolios against the impacts of inflation. 

Higher inflation rates can put upward pressure on interest rates, as lenders will usually want higher compensation to part with their money. This is because they will be unable to buy the same level of goods and services with it in the future. 

Inflation can also result in central banks tightening credit conditions to slow economic growth and lower pricing pressures. 

Higher interest rates can put downward pressure on the value of certain investments. This is especially true for more speculative and higher growth ASX shares, as well as those with long-term income streams. As inflation and interest rates rise, the current value of those income streams is discounted by a higher factor. 

Why inflation is important to investors

In 2022, COVID-19, natural disasters, and geopolitical tensions caused by the Russia-Ukraine conflict are impacting global supply chains, resulting in stress at the checkout for consumers. ASX shares have also been impacted as investors seek higher returns to compensate for inflationary effects. 

Inflation eats up the real value of money, so investors are concerned about the impact on their portfolios. A higher inflation rate means investors need to earn a higher rate of return to break even in real terms. 

Inflation can also put pressure on share prices. Shares trade on expected future earnings, which are discounted to calculate their current value. As interest rates and inflation rise, so does the discount rate, which tests share price valuations. 

Investors may seek to safeguard their portfolios by moving to ‘safe haven’ assets such as  gold and value shares

Gold is not a perfect inflation hedge, as it pays no dividends, but it has tended to hold its value over time. Value shares have strong current cash flows and might be expected to grow at a slower pace. 

Growth shares, on the other hand, have low cash flows now but are expected to generate significant cash flows in the future. Higher inflation and interest rates are likely to have a larger impact on growth shares because their future cash flows are impacted more by an increase in the discount rate

Gently rising inflation is generally seen as a positive for the sharemarket, as it is consistent with the economy growing at a sustainable pace. But inflation above a certain level becomes problematic, although the impact differs depending on your investment style. 

Higher inflation comes with higher interest costs, higher costs of materials and labour, and reduced expectations of earnings growth. The effects of inflation, however, are one of the key reasons to invest. As cash loses its value over time, you need to invest in some way if you want your money to retain (or grow) its purchasing power. 

Investing in ASX shares can produce gains above the inflation rate, allowing investors to make money in real terms. Savings accounts provide interest payments but they may not keep pace with inflation in the current low rate environment. 

The key thing is to preserve the value of your money over time. Investing does not have to be complicated –a few ASX exchange-traded funds will do – but by not investing, you run the real risk of inflation eroding your purchasing power. 

 

Last updated 6 April 2022. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

Learn More About Investing with The Motley Fool

Interested in learning more about investing? Then be sure to browse our "Investing Basics" knowledge hub, which we've created to help more people learn about the wonders of investing. It's just our small way of helping make the world Smarter, Happier and Richer.