Inflation is simply the general increase in prices of goods and services over time. As the rate of inflation increases, your purchasing power reduces. In effect, when there is high inflation, your money is unable to buy as many things as it did before.
What causes inflation?
A mix of demand-pull and cost-push factors. Inflation occurs when the purchasing power of a country’s currency shrinks to a level that the supply exceeds demand. Alternatively, if the central bank of increases the money supply without an equal increase in productivity, inflation occurs. In such an instance, there will be more money in circulation, given supply constant, general prices increase. Rising Wages, High Import Prices, High Raw Material Prices and Higher Taxes also induce a high inflation environment.
Changes in exchange rates can also cause the value of forex to plummet in relation to the local currency. This depreciates the value of the local currency, imported goods become more expensive and costs rise, putting pressure on prices.
Fiscal policy induced
Government’s fiscal policy position can also cause inflation. For instance, general price increases happen when a government imposes new tariff. This tariff increase will increase cost of production or import, and in turn affect the general prices of goods and services.
Why should you care about inflation?
Many people see inflation as a double-edged sword that hurts businesses and consumers alike. However, inflation can also be a good thing. When prices rise due to an expanding economy, this is often accompanied by an increase in wages and income, since a robust economy means lower unemployment and more intense competition for labour. So, your favourite sandwich for example might be more expensive, but you can afford it since your paycheck may increase in an inflationary environment.
If prices go up because of tariffs (taxes on exports and imports), this can cause goods and services to be more expensive without a corresponding increase in incomes. That hurts, and you will want to give a second thought to inflation.
What is more, you should care about inflation because it impacts what you can do with your money. How so? As the prices of goods and services increase, the purchasing power of money falls. The implication is that, with the same amount of money, you won’t be able to buy the same number of items today as you would have several months ago.
Another reason to care about inflation is that it affects how you manage your money. If inflation is at 23.6%, you will naturally be inclined to put money into investment products that pay higher than that rate. This will ensure that every income earned retains its purchasing power over the long haul.
How inflation affects you
While inflation affects each of us differently, it broadly affects consumers in terms of both income and expenses. Here is how inflation personally affects you:
Cost of housing
Inflation may also affect the cost of housing. If you currently rent your home, your landlord may increase your rent every year to account for inflation.
Your retirement plan is at risk.
For retirees, rising prices from inflation will only present additional risks. If you’re like many Pensioners and operate on a fixed budget, absorbing higher costs can hit you hard. You may also be paying for hefty medical expenses beyond the rising costs of food and housing.
It becomes more expensive to borrow.
Usually, when inflation rises, your salary or wages should be adjusted accordingly in what is known as a cost-of-living adjustment. However, if inflation increases, but your wages stay the same, your money will not cover as much as it previously did. You may choose to borrow money to bridge the gap, which will come at an extra cost since interest rates tend to follow inflation.
What you should do in an inflationary environment
Inflation erodes the purchasing power of your money, so you must be strategic in protecting your money from it. Here is what you should do to neutralise inflationary pressures:
Do not hold your money
The rate of interest on holding your money is zero. Thus, the first thing to do in an inflationary environment is to take out 70% or more of all the money you do not have present need from a regular savings or current account. Keeping your money this way will only cause it to lose value over time, and the longer you hold it, the more inflation will reduce its purchasing power.
The most ideal thing to do is to deposit your money in a trusted investment account that matches your personality with the help of a licensed investment advisor.
Negotiate a salary raise
You will feel the effect of inflation if your annual salary does not keep up with the inflation rate. As a result, you can protect your money from the impact of inflation by negotiating a salary raise. This will ensure your salary is adjusted to cover cost-of-living expenses.
Put most of your money in investments
Another action to take in an inflationary environment is to invest most of your money. When you put your money in stocks and bonds for long-term growth, you stand a higher chance of earning returns that beat inflation.
Review your expenses
Inflation will cause your costs to increase, so it is time to review and rethink what you need to eliminate from your household basket. Eliminating any unnecessary expenses will give you more purchasing power for the essentials of life.
How can you plan for inflation?
Inflation is unpredictable. That is why you should always be aware of the risk it poses for your finances. So, how can you plan for inflation?
Invest in stocks
Although many people express a lack of confidence in stocks, owning equities can put you in good financial shape if inflation kicks in. Some of the best stocks to own are those in the consumer staples sector since these companies produce and sell items that are essential for everyday living. As a result, consumers will buy them irrespective of prevailing market conditions.
Equities tend to offer better protection against inflation. Company revenues, and therefore earnings, can outpace inflation over time. Over the last 20 years, equities have delivered returns approximately 6% higher than inflation globally.
Diversification is key
A diversified portfolio with the right mix of equities and fixed income investments can help you grow returns faster than inflation and thus build wealth. Equity funds can provide the benefit of capital growth and dividend income during times of economic uncertainty.
For example, it can help to add exposure to companies with ties to commodities, real estate, or those with the ability to pass on price increases to their customers without impacting demand.
Fixed income investors are often enticed by the stable stream of income bonds provide. However, inflation and interest rates tend to move in the opposite direction from bond prices. When interest rates rise, it can reduce the value of your bond holdings.
While inflation may impact areas of the bond market in the near term, bonds play an important role in diversified portfolios by providing stability against equity market volatility. Consider bonds with a variety of characteristics including maturity, various risk levels, as well as sovereign and corporate bonds, both domestic and global.
While you cannot avoid the effects of inflation altogether, having a solid financial plan should guard you against inflation and help maintain your buying power and standard of living.
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