What is inflation?

Last updated on 7 April 2020

How inflation teams up with time to rob you! What is inflation?

We know that moment all too well standing at the pay point, card in hand; the sudden realization that the cost of our groceries has spiraled upwards over time. We cannot quite put our finger on what exactly led to the increase or when it crept in, but we know it’s definitely apparent. Think back a little further and you might even reflect on how what you’ve just spent on a couple of packets of groceries might have bought you a trolley-full ten years ago. Where and how did that all happen? What is inflation?

Per its true definition, inflation is ‘the sustained increase in the general price level of goods and services in an economy over a period of time’. In short, it means that what your ten rand note bought you a couple of years ago will end up not being able to buy those exact same goods or services today. What inflation does is to reduce the purchasing power of your money.

Inflation is not a South African anomaly – far from it. Inflation exists in every country around the world, though the exact cause of its existence, appreciating its severity, as well as how to combat it, remains a contentious issue.

The official measure for inflation in South Africa is the Consumer Price Index (CPI)[1]. Media reports containing the word CPI generally also include the South African Reserve Bank (SARB), as it is the SARB who is responsible for managing the rate of inflation in South Africa through formulating and implementing monetary policy.

The SARB increases interest rates in an attempt to put the brakes on the economy and lower inflation, while otherwise lowering interest rates to encourage spending and to stimulate economic growth by making access to money cheaper.

At the time of publication of this article, the official rate of inflation in South Africa as measured by CPI was 4.0%. This is in line with the SARB target of keeping inflation between 3% and 6%. Inflation changes all the time as prices go up (and sometimes down). You can get these stats directly from Statistics SA here.

Why should you care about inflation?

What is crucial for you to take from this article is that in the absence of putting your money to work, inflation is guaranteed to erode your wealth as sure as time passes by. So if you do nothing with your money, it will become less valuable over time.

If you had stashed R1,000 under your mattress for the last three years and hauled it out this afternoon, it would still have the face value of R1,000 however it would likely now only buy you goods and services to the value of about R830, just because time did its thing.

So how does one put one’s money to work?

How do you ensure that money saved today retains its purchasing power for a future date?

In the case of cash, it’s pretty simple; earn interest.

Cash can be kept in many different accounts, assets or places. In most circumstances a standard cheque account or transactional account with a bank will not yield you any meaningful interest, which is why it is generally not desirable to keep large cash balances in these accounts.

Money market unit trust funds, or designated savings accounts with advertised rates of interest are more appropriate places to keep meaningful cash balances as these will likely offer you interest that compensates you for the loss of the purchasing power of your money.

A savings account offering an annual rate of interest of 5% is referred to as the nominal rate of interest; after one year you would have 5% more money in your account than you started with.

Against that nominal interest, one needs to consider the rate of prevailing inflation. If inflation was at 4%, the true growth of your money in purchasing power terms would only be 1% (5 less 4). This true rate of return is called the real rate of return. A real rate of return is that return which is achieved after taking into account the rate of inflation.

It is very difficult or near impossible under current market conditions to get a real rate of return on your cash that appears attractive. This is because inflation is running at or near 4.0%, while you’d be very lucky to find an interest rate on cash that allows you to draw your money out immediately, in excess of 6.5%. In this case, the real return would only be 2.5%.

Putting your cash to work in almost all circumstances is not so much about earning a meaningful real return; it’s about achieving a real return at all.

In South Africa’s current low interest rate environment one should be very happy to simply retain the purchasing power of one’s cash savings, which at least ensures that any money set aside for a future purpose, will have as much purchasing power as it did the day you stashed it away.

Consider your existing cash holdings.

What rate of interest are you earning, and what’s your real return?

If you are not being compensated for the effects of inflation, shop around and find a place that best preserves your savings. Enquire from your bank what rate of interest you are earning on any of your larger cash balances. Note that no cheque or transactional account will give you any decent interest, so don’t lambaste your bank when you discover that you’re earning 0.1% on your cheque account – it’s not designed to pay you a meaningful rate of interest.

Lastly, your pursuit of a real return should not just be limited to your cash holdings; apply an inflation-adjusted mindset to all your investment decisions.

[1] You may also hear or read about a variant of the CPI called the CPIX. It is based on the CPI but does not consider the effects of bond costs.

When simply saving for a rainy day, or an Emergency Fund, make sure that you’re earning interest and at least hold your monies buying power!