What is inflation?
You’ve probably run into some pretty inflated egos at one point or another in your life, especially if you’ve lived in the middle east for a fair amount of time (2 days or more). Unfortunately I will not analyze this phenomenon in this post.
Instead, I’ll discuss something way more interesting. Inflation. What it is, why it’s important to understand, and why you need to beat it.
Do you remember the “when I was your age” stories our parents and grandparents used to share with us as kids? Didn’t you find it odd a packet of Chiclets gum used to cost them like a million times less than what it costs today? Or if you tried to withdraw from an ATM what they claimed was their weekly allowance back then, you’d get: “Error! Please enter an amount in multiples of 10 AED”?
Cost of goods and the general cost of living in the 1960s was significantly less than what it is today. Everything from food to cars and real estate has gotten more expensive over time — much more expensive! We don’t really feel it one year after the next, but make no mistake, it is happening.
This increase in the general price of stuff is totally normal, and it is what we call inflation.
How exactly do we measure inflation?
To measure inflation isn’t a very straight forward problem for governments to solve. Today, they put together a basket of goods that represent the most common “stuff” consumers buy. The cost of this basket over time defines inflation.
In the U.S. this basket is called the Consumer Price Index (CPI) and measures changes in the price of consumer goods & services such as gasoline, food, clothing and automobiles. How are these prices measured? Surveys. Literally.
The relationship between inflation & interest
Inflation and interest are very closely related. Interest rates in a country are set by the central bank of that country. In the United States, an entity called the Federal Reserve Bank (aka The Fed) sets U.S. interest rates. These often impact interest rates all over the world, especially here in the Middle East. In fact, interest rates in the UAE are pegged to those in the U.S.
The Fed (sounds pretty cool, doesn’t it?) uses several factors to determine interest rates. A major one of these factors is, you guessed it, inflation. Too much or too little inflation is not good for the economy, so the Fed tries to control it by using interest rates as a lever.
When The Fed lowers interest rates, people are discouraged from saving (nobody wants to earn low interest rates) and encouraged to spend (cost of loans becomes cheap). This results in growth in the economy, and therefore higher inflation.
When The Fed raises interest rates, the opposite happens. People save more and spend less. This results in a slow-down of the economy, and something called deflation.
How does inflation affect our lives & our investing?
Keep up with Inflation
If it appears you are in a constant race with inflation, you are correct! As investors, the absolute bare minimum we can do is keep up with it. That means if you can grow your savings by the exact same rate as inflation, you will not lose money. Inflation usually falls between 2-3% per year, but this is by no means a guarantee. Sometimes it’s more, sometimes it’s less. It really depends.
What’s important to remember is you cannot afford to park your money in a checking account that earns 0% interest per year, or you’d effectively lose 2-3% per year.
At this point you may think, “Hang on a minute, even my savings account doesn’t pay me 2% per year!”. And your shock is absolutely justified. Saving your money in a bank account is nearly never a smart idea as it nearly always underperforms versus inflation.
Instead, you should look at alternative investments that offer liquidity and low long-term risk (eg. the stock market). We will cover more on this topic in the coming posts.