What is Inflation?

You’ve heard the story of the ant and the grasshopper – the ant works hard and saves up all summer, while the grasshopper lazes about, working only when he has to. In the end, the grasshopper freezes, caught out in the cold without enough food, while the wise ant continues to prosper, eating from the stockpiles he made during summer.

Life can be hard when you’re part of the bug kingdom.

No one wants to die in the cold like that carefree grasshopper. And to avoid his story, we’re all taught from a young age to be like the ant – to work hard, put away money so we can live comfortably through retirement.

But what if the value of that money, despite all your saving, is actually decreasing over those years? Kind of confuses the moral of the story, doesn’t it?

A Few of Life’s Certainties: Death, Taxes – and Inflation

Whether insect or human, savers face a problem – the longer you stockpile, the more you’ll give up to rot. For diligent people, that rot is inflation, and it’s siphoning about 3% of your savings every year. But instead of microscopic microbes destroying your stockpiles of food, it’s a concept slowly chewing through the purchasing power of your bank account. Unlike the rate of rot, the rate of inflation can be measured, and (lucky for all of us), to some extent, controlled.

At times throughout human history, Inflation has been as high as a couple hundred per cent, or as low as 0% (or even reversed, which is known as deflation). However, in recent decades, it has averaged between 2% to 3% annually and is expected to stay there for the foreseeable future. That means the $1000 dollars you put away last year has the buying power of $970 (last year dollars) now. Meaning, it buys less than it did last year. Let’s put that into perspective over a longer term.

Your Dream Car (driving away from you at 3% per year)

Let’s pretend, for now, that your dream car is worth $10,000 (wouldn’t that be nice). You can take out a loan and buy it today, at $10,000, or you can put away $1,000 a year and save up. In the second scenario you’ll have just enough money saved to buy your car in ten years. Or at least it seems like that. However, in real life that’s not the case, because in real life we have inflation.

That means, if inflation stays at 3% per year, the car you want to purchase will now cost $13,439.16 – which means you’re going to have to wait another four years (three and a half, technically, but four for ease of math) before you can buy your dream car. But, wait, during those four years, inflation won’t stop increasing the cost of the car.

In four years, the car will cost $15,125.89, meaning you’re closer, but still can’t afford it. So, another two years of saving is in the cards. Eventually you’ll catch up, but you’ll end up paying a lot more for your car than if you had purchased it on the spot.

How is Inflation Measured?

Inflation is complex, dealing, as it does, with the price of literally everything. However, economists have figured out a way of tracking it. It is, of course, impossible to measure the price of everything, every year, so it can be compared to last year’s price of everything, and the preceding year’s price of everything (mental headshake).

The answer, economists have found, is to create a way to chart the increase (or decrease) in the price of goods and services by making price indexes. So, instead of following the price of everything, economists choose a variety of goods and services that are representative of the economy, and track and compare those.

In North America, there are two main price indexes used to measure inflation:

• Consumer Price Index (CPI) - An index that includes representative consumer goods and services such as gasoline, food, clothing and automobiles. Prices are averaged for each category and measured against each year-to-year. The CPI measures inflation from the purchaser’s point of view.
• Producer Price Indexes (PPI) - A family of indexes focused on the price of products from domestic producers. PPIs measure inflation from the seller’s point of view.

Of course, those numbers don’t always show a simple increase. Variations include:

• Disinflation – a slowing rate of inflation
• Deflation – the opposite of inflation
• Hyperinflation – excessive inflation, sometimes over 100%
• Stagflation – a combination of a stagnant economy and inflation

Inflation – The Good, The Bad, and The Ugly

In the end, most people just want to know: is inflation good, or bad? And, as you can probably guess, the answer is a little less black and white than the question: it depends.

However, for those trying to save money for the future, the answer is a bit simpler: it’s bad, as it erodes the purchasing power of your savings.

If you’ve taken on a loan to buy a home or property, you’re benefiting from inflation, making it good. As your purchase is growing in value, while the money invested in it essentially stays to same. If your borrowed at less than a 3% interest rate, your house will increase in value faster than your loan cost – meaning you pay less over the course of the loan than your home is worth.

Managing Inflation

Inflation is a fairly simple concept, but when trying to fit it into you financial plan, things can get complicated quickly. Whether borrowing, or investing, inflation needs to be taken into account with every step.

Don’t let inflation confuse your financial plan. Let Bayview Financial tackle your savings to ensure inflation doesn’t get the best of you. Call us today and take your first step on the road to financial security.