Inflation is a term that is thrown around a lot these days, but what does it mean? Today I’ll explain what inflation is, how it works, what causes it and how you can beat inflation in Australia. I’ll also explain who it negatively impacts and who it benefits, to help you ensure that you make inflation work for you, rather than against you.
Inflation refers to the decrease in the purchasing power of a currency or form of money. This results in an increase in the cost of general goods and services within an economy. As a result, the purchasing power of the dollar diminishes over time, as products and services continue to increase.
According to the Austrian school of economics, Inflation occurs when a nation’s money supply growth outpaces economic growth. In other words, the money supply increases, making the dollar less scarce. Goods and services, however, remain unchanged in their productivity and quality. As the dollar devalues due to its supply being increased, more dollars are then needed to cover the costs of these goods and services.
The increase in the cost of these goods and services results in inflation and the diminished purchasing power of that currency. This leads to the general cost of living for the common public increasing, which leads to a deceleration in economic growth.
However, while an increase in the monetary supply is often the root cause of inflation, this can play out through different mechanisms.
In economics, the three main mechanisms that drive inflation are:
Demand-pull inflation occurs when an increase in the money supply occurs, driving up consumer spending habits at a rate that exceeds an economy’s production capacity. This is more commonly referred to as supply and demand.
For example, the government might issue a stimulus cheque to the public with the intent of people using this newly acquired money to buy goods and services. In this example, let’s assume that there’s a new iPhone that is being heavily marketed.
Due to people having this newly acquired money, there will be a wider market of potential customers for the iPhone, as more people are capable of affording one. Apple, however, has not increased its ability to produce more iPhones, as this growth in consumer spending is the result of an increase in the supply of money, not the supply of iPhones.
Subsequently, there is now a much higher demand for iPhones despite the supply being unchanged. Apple can, in turn, increase the price of their iPhone, as there is more demand for what has now become a scarcer asset.
With Demand-pull inflation, this occurs across multiple goods and services as not everyone will spend their newly acquired cash in the same way. This can drive up the costs of many common goods and services such as transport, groceries, cars, technology and luxury items, leading to increased inflation.
Cost-push inflation occurs when an increase in the cost of production occurs. As the cost of production is increased, companies then begin to reflect this increase by raising the prices of their goods and services, leading to inflation. This can occur through a variety of different measures, such as minimum wage for workers rising, a shortage in materials, increases in the cost of transport and logistics etc.
For example, a natural disaster may occur that temporarily shuts down an oil drilling company. Due to the company being shut down, the oil will then become scarcer, driving up its price. The company may then have to increase its petrol prices upon reopening to recoup their losses from the natural disaster. While this is occurring, other companies have to spend more on transport and logistics, as it is more expensive to drive items across the country due to the spike in fuel prices. This then becomes reflected across goods and services and drives inflation.
To distinguish between the two: Cost-push inflation is driven by supply costs while demand-pull inflation is driven by consumer demand
Built-in inflation occurs when as a collective, it is expected that current inflation prices of common goods and services will continue to increase at a similar rate in the future. This leads to the expectation that workers will need their salaries to increase at the current rate of inflation, to be able to afford the same standard of living over time.
This leads to a perpetual cycle where an increase in worker salaries, leads to an increase in the cost of goods and services by companies to cover their worker’s salary increases. The increase in goods and services then leads to workers expecting their salaries to increase at a proportional rate which leads to an increase in the cost of goods and services and so on.
The most typical method for measuring inflation is via price indexes. Prince indexes measure the price of a basket of various goods and services commonly used within society. The most common price indexes are the Consumer Price Index (CPI) and the Producer Price Index (PPI). However, there are lots of arguments as to whether these indexes accurately measure inflation.
CPI is used to measure the weighted average of prices of a basket of various goods and services which are classified as primary consumer needs. The CPI consists of various essential needs such as housing, food, health, transport, communication and a variety of other services. CPI is calculated by comparing the average price of these goods and services to their average price at a prior time in history.
This formula breaks down to:
“Cost of products or services in a current period / cost of products or services in a previous time period x 100 = consumer price index.”
The CPI is typically used to assess changes associated with the cost of living. As such, it is the most commonly used index to identify periods of inflation and deflation for everyday people.
According to the most recent data, the CPI in Australia rose 3.5% from December 2020 to December 21 and is forecast to continue increasing. More recent information was released in February 2022 from the US, identifying inflation at a much more significant 7.9%. You can view these data sets here:
The PPI is a family of industry indexes that measures the average change over time in selling prices as they leave their place of production or as they enter the production process. Unlike the CPI which measures price changes from the consumer’s perspective, the PPI measures price from the perspective of the seller.
There can be variations between sellers’ and purchasers’ prices due to a variety of factors such as distributions costs, taxes and government subsidies. As such, both indexes are commonly used together to gain a more holistic overview of inflation figures.
A main objective of the PPI is to serve as an aggregation price index that can represent the overall supply and demand conditions regarding goods and services within an economy. Produced monthly by the Bureau of Labor and Statistics (BLS), the PPI is broken down into three categories:
Commodity-based products are fungible, meaning that they are interchangeable with products offered by other companies. These can include things such as rubber, nuts, bolts, wood, steel and oil. Commodity-based industries compete with one another typically through pricing, as they offer similar products.
Industrial products are intended for use in making other products or operating a business/institution. Products under this classification include raw materials, component parts, accessory equipment and operating supplies. These differentiate from consumer products based on their use case. While consumer-based products are intended for individual or private use, industrial-based products are materials and services used to operate a business. This can then lead to the production of consumer-based products.
The FD-ID structure measures price changes in goods, services and construction sold to final-demand and intermediate-demand producers. There are two primary classes of buyers included in the FD-ID system: these are final demand and intermediate demand.
The final-demand component of the FD-ID system is used to measure price changes for commodities that are sold as personal consumption, capital investment, government purchases and export. This includes both unprocessed and processed goods.
Final-demand goods include construction and machinery for private capital investment, diesel and jet fuel for government and organic chemicals for export. Final-demand services include consumer loan services, passenger air transportation and apparel retailing margins.
The intermediate-demand component of the FD-ID is used to measure price changes for goods, services, maintenance, repairs and construction, sold to businesses as inputs to production. Unlike final demand, this excludes capital investment. Intermediate demand is measured by production flow and is a stage-based system of price changes for goods, services and construction as they move through the production chain of the economy to final demand.
The most popular measure of inflation for average people (consumers) is the CPI. As the CPI is a measure from the point of view of consumers and is designed to reflect the prices of goods and services within most people’s budgets. However, the CPI is not without its faults.
Firstly, the CPI focuses primarily on the buying patterns of urban consumers. As such, it has been argued that it is not a reliable indicator of the spending habits of consumers in rural and remote areas.
Secondly, the CPI only captures a fixed bag of goods and services. This can be problematic when blanketed across large demographics, as a rise in fuel prices will be irrelevant for someone who cycles to and from places. Similarly, rising meat prices won’t necessarily impact vegans and vegetarians and so on.
Lastly, CPI’s basket of goods and services are weighted. This leaves the CPI prone to manipulation, as if one good or service increases exponentially in cost, it can have its weighting reduced during a reporting period. By doing this, the inflation percentage can be manipulated to a lower or higher degree, as goods and services with low-cost increases may be overweighted and vice versa.
Due to these discrepancies, some economists argue that PPI is a better indicator of inflation, as it covers a wider scope of goods and services. However, it is often overlooked in favour of the CPI as the PPI measures inflation from the view of producers’ costs.
Despite this, the PPI serves as a leading indicator for the CPI. The reason for this is that when production costs increase, the producers are likely to increase the cost of their goods and services to recoup the additional expenses that they have incurred. Subsequently, retailers increase their costs to offset their additional expenses which are then passed onto consumers, leading to an elevated CPI.
It should be noted that PPI also cannot be used exclusively, as it does not include sales and excises taxes which apply to consumers but not producers. Subsequently, the best indicator for inflation is to combine the two indexes. The CPI can provide a decent indicator for inflation in general costs of living. Similarly, the PPI can be used to determine increases in production costs, which acts as an early indicator for a rising CPI.
Inflation has the potential to significantly change a person’s quality of life, as it can have significant impacts on their investments and stores of wealth. For example, people who save their money or live off of a fixed income such as annuities and pensions tend to struggle during periods of high inflation. This is due to the money they hold/live off of diminishing in value over time.
Conversely, people who have fixed-rate loans on hard assets such as real estate can benefit from inflation due to the payments. This occurs as homeowners owe the same amount throughout the loan, despite the owed amount diminishing in value over time due to the circulating money supply increasing. Similarly, hard assets such as real estate and precious metals remain scarce and subsequently, tend to retain or increase in value during times of economic inflation.
Subsequently, whether you’re a saver or a spender, a consumer or an investor, periods of high inflation can significantly impact your overall net worth, investment and consumer habits.
As a general rule of thumb, savers, people without hard assets, people on fixed-income and consumers tend to suffer the most during periods of high inflation. These demographics tend to suffer more if the inflation rate remains positive and their incomes remain stagnant, as their standard of living will drop as their income diminishes in its purchasing power over time.
For example, let’s imagine that a family has a fixed household income of $50,000 per year and that it remains at that rate for five years. If the inflation rate is 10% per annum and remains at this rate during the five years, prices will be one and a half times greater at the end of the 5 years. That family’s $50,000 will then have a purchasing power worth only two-thirds of their original purchasing power at the end of those 5 years. Under these circumstances, the same amount of money will only be able to buy 66.7% of the number of goods and services that it could during the first year.
Similarly, pensioners who have all of their superannuation stored in cash or fixed-interest will suffer, as the dollar devalues over time. As a result, their pension will diminish in value as it begins to afford less and less.
Younger people who are saving for homes or trying to accumulate a large amount of cash to purchase expensive goods will similarly suffer, as the cash they are accumulating progressively loses its purchasing power. For prolonged periods of high inflation, this can cause a cycle where their cash devalues, meaning they have to save for longer.
This can be worsened for first time home buyers, as housing prices tend to increase during periods of high inflation while their deposit lowers in value. Subsequently, as housing prices rise, this demographic needs to save more money which is progressively losing its purchasing power. This can lead to wealth inequality, particularly for people without exposure to assets that benefit from inflation.
Interest rates and inflation tend to move in the same direction. Therefore, during periods of prolonged inflation, interest rates tend to rise. This discourages people from borrowing more money and is intended to provide a cool-off effect, where the economy is less stimulated by leveraged debt. It also becomes more expensive for banks to borrow money from the federal reserve, leading to increases in loan interest rates for consumers and banking customers.
For people with loans, particularly on depreciating assets such as cars and other luxury items, this often leads to higher repayments. Similarly, credit card rates can also increase, making debt a more costly affair. This is true of most debt-related purchases, except for appreciating assets which can increase in value at a rate greater than the interest owed. Examples of this can include real estate and shares.
However, even debt that has been used to purchase growth assets can be detrimental if the borrower has a adjustable/variable interest rate. Simply put, as it becomes more expensive for banks to borrow money, they then increase the interest payments on their loans to remain profitable.
This allows banks to continuously increase the interest rates charged on their loans, which can lead to borrowers being unable to make their repayments. This was a catalyst for the 2009 global financial crisis, as a rise in interest rates on variable home loans led to millions of Americans defaulting on their mortgages.
The main demographic that can beat inflation in Australia are investors. This can include real-estate investors, commodities investors, some stock investors depending on the sector and while relatively untested, potentially Bitcoin and some other cryptocurrencies.
Houses are considered a hard asset, as it is tangible and has a physical use-case of providing shelter. They’re also finite, as there is only so much land within a given area. For this reason, real estate tends to appreciate at a rate greater than inflation, making it a relatively reliable hedge against inflation.
For people who don’t own their houses outright, fixed-rate mortgage holders tend to benefit the most in inflation. Simply put, as money becomes more abundant and drops in value, the fixed payment that they’re making remains unchanged. This leads to owners covering their mortgage payments with devalued dollars, saving them in the long run. The opposite of this is variable-rate mortgage holders who have their interest rates rise alongside inflation, making it more expensive to pay off their debt.
Alternatively, if people do not have enough capital for a house deposit or simply want exposure to real estate without having to purchase a house, real-estate investment trusts (REITs) tend to hold up relatively well during high inflation periods. I cover REITs in more detail here if you’d like to learn more about them:
Stock investors can benefit from periods of inflation, depending on what sector they invest in. While speculative growth stocks tend to perform well in periods of low inflation, they can get hit hard during prolonged periods of inflation. This occurs due to growth stocks being more highly leveraged in general, which can lead to greater interest repayments during inflationary periods. Alternatively, value stocks that provide lower but more reliable cash flows tend to perform better.
Sectors such as consumer staples, healthcare, utilities and energy tend to perform well during inflationary periods. As these sectors provide goods and services that people need, the costs that these industries charge for their goods and services can be raised proportionately in line with inflation.
Due to these services being considered essential, consumers are forced to pay regardless of the price increases as they are necessary for daily living. From an investing standpoint, these stocks and industries can then grow at a rate that outpaces inflation.
Investors can gain exposure to these stocks either by buying them directly on the Australian Stock Exchange (ASX) or by buying sector-based Exchange-traded Funds (ETFs) which contain an index of companies within a particular market/sector.
For more information on how to purchase stocks or what ETFs are, please refer to the following guides:
Hard commodities are natural resources that need to be mined or extracted. These include gasses and oils. As well as metal ores such as gold, platinum, copper and iron. Since these items are relatively finite and can only be produced at a specified rate, they tend to retain their value well.
Commonly used hard commodities such as gas, oil and iron can raise in value, as their demand remains high during periods of inflation. This allows exporters of these commodities to raise their prices as they see fit, since consumers still rely on these products. As mentioned previously, investors can gain exposure to these companies and sectors through shares and ETFs.
Gold, in particular, is considered one of the best wealth-preservation assets due to its strong monetary properties. It is hard to destroy and counterfeit has a finite supply, is universally accepted as a medium of exchange and has a long track record of retaining its value. This is why gold was used as the main form of money for thousands of years until Nixon abolished the gold standard back in 1971.
As such, gold can be used as a reliable method of beating inflation in Australia, due to its unique features. In periods of prolonged hyperinflation, gold also tends to rise significantly in value as more investors seek to store their wealth in hard assets such as gold. You can buy gold directly or gain exposure to it through ETFs such as PMGOLD.
While controversial and relatively untested due to Bitcoin emerging in 2009, it makes sense that Bitcoin Beat Inflation in Australia – acts as a hedge against inflation. Introduced following the 2009 global financial crisis, Bitcoin emerged as a finite global currency that could be used without intermediaries. While it started as a currency, it has over time grown more utility as a store of value (albeit a volatile one).
While gold has traditionally been seen as the hardest form of money, Bitcoin is proving better in this regard. Whereas gold can be mined at greater rates due to advancements in technology, Bitcoin has a finite supply that is capped at 21 million. Its mining rate halves every 4 years, meaning its production output is programmed to halve during each 4-year interval. This means, that Bitcoin is mathematically programmed to be the most deflationary asset in history. As such, while it is relatively untested, it remains the most deflationary asset which makes it by virtue, one of if not the strongest hedges against inflation.
For more information on what Bitcoin is, how it works and its monetary properties, I have written the following in-depth guide. I also recommend using Digital Surge to purchase Bitcoin, as it is an Australian-based crypto exchange tailored to Aussie investors.
Prolonged periods of high inflation can be seen as detrimental, particularly to consumers as the dollar diminishes in value. However, as previously discussed, there are ways to prepare for prolonged inflation and even prosper during these periods with proper planning. The following steps provide a way of mitigating the negative effects of inflation and even profiting from it.
The first step for dealing with inflation is to set up a budget. As the cost-of-living rises, it becomes more important to look at your spending habits and ensure that you’re getting the best possible deal. By constantly looking for better deals on a range of mandatory expenses such as food, housing and insurance, you can increase the amount of money that you’re able to save. This saved money can then be used as a buffer in times of financial hardship and eventually, to invest in assets that hedge against inflation.
Additionally, setting a budget allows you to determine how much money is required to cover your essential needs and wants. Needs are things that you physically need to live your life. It can include things like housing, electricity, food, water and transportation.
Wants are non-essentials that may enhance your quality of life but aren’t necessary for survival. These include things like eating out at restaurants/getting take-out, subscriptions to streaming services, movie tickets and other luxury items. In times of prolonged inflation, the cost of essential goods and services rises, making it less affordable.
You can offset this rise in cost by eliminating or reducing the amount you spend on wants, allowing you to continue to afford your basic standard of living.
For more information on how to calculate a budget or tips and tricks that I use to save more money, I have written the following guides:
Prolonged inflation can lead to continuous increases in the cost of living and in some instances, a recession. For this reason, it’s important to have an emergency fund that can act as a safety buffer against unexpected expenses. These expenses can include losing your job, your car needing a major service, an unexpected dental bill etc.
Emergency funds are typically anywhere from 3-12 months of your living expenses and are stored in high-interest savings accounts. They are only used in genuine emergencies and are separate from other savings funds such as holiday accounts.
Emergency funds are great because they provide peace of mind, as you have a safety net to fall back on should something unforeseen happen. Additionally, they mitigate against being forced to incur debt through loans or credit cards when large expenses are suddenly incurred. As mentioned earlier, these forms of debt are particularly dangerous in periods of high inflation, as the repayment rates can be raised sharply.
For more information on how emergency funds work and how to establish one, please refer to the following guide:
Bad debt is debt that is owed on a depreciating asset. This can include anything from cars to phone plans and credit card expenses. Therefore, negative debt generally refers to loans that weren’t issued to purchase an appreciating asset such as real-estate of ETFs and shares.
Due to interest rates rising during periods of inflation, it’s important to try and pay off these bad forms of debt as quickly as possible. By doing this, you mitigate against being forced to make higher repayments to cover items that have already dropped in value. If you have particularly high-interest payments on loans or credit cards, it may be more beneficial to follow this step before setting up an emergency fund. However, it varies depending on the amount of debt owed and whether you want to establish an emergency fund first or pay off your debt.
Additionaly, if you are worried about rising inflation rates, it may be worth considering shifting any variable/adjustables loans to fixed-rate. This can act as a hedge against inflation should it remain continuous.
For more information on methods to pay off debt, please refer to the following guides:
If you’ve reached this step, you’ve managed to save more than you spend, establish a reliable emergency fund and pay off your bad debt. The next step is to invest the surplus of money that you save after receiving your salary. As previously mentioned, there are a range of asset classes and stores of value to choose from that include but aren’t limited to:
There is no right or wrong answer when it comes to which asset class you choose, as it varies depending on your knowledge and available capital. As such, I highly recommend that you do your own research regarding each asset class to find one that best fits your unique circumstances and investment strategy.
Inflation can be caused through a range of different mechanisms. These mechanisms include demand-pull inflation, cost-push inflation and built-in inflation. Regardless of the mechanism, inflation is almost always the result of a nation’s money supply growth outpacing its economic growth. This outpacing growth of the money supply results in the diminishing purchasing power of the dollar. As a result, the cost-of-living increases, significantly impacting the lives of citizens within that country.
Due to the consequences of inflation, it’s important to have an understanding of how a continuous rise in inflation can impact a society. Inflation is detrimental for savers, people on fixed-income, pensioners and people with variable debt. This is due to this demographic being reliant on cash which is diminishing in value or loans which are increasing in value.
However, inflation isn’t always doom and gloom. It can be beneficial to people under the right circumstances. People who benefit from inflation are those with tangible assets such as real-estate and hard commodities like precious metals, gasses and oils. Investors in inflation-resilient industries such as consumer staples, healthcare and energy can also benefit during periods of high inflation. Lastly, those with exposure to finite stores of value such as Gold and Bitcoin can effectively hedge against rising inflation rates.
Therefore, if you’re worried about inflation the best things that you can do are as follows: