Understanding the real cost of inflation

Inflation occurs when the general level of prices for goods and services is rising. This often results in a reduction in buying power.

In Australia it is measured as the Consumer Price Index (CPI) which measures a basket of everyday goods and services, and tracks the prices of those goods and services over time.

What is the current inflation rate?
Inflation is currently 3.0% for the September 2021 quarter, comparing year-on-year.  This sits within the RBA’s target rate of 2-3%.

How does inflation impact me?
Inflation means your dollar buys less.  It assumes that the buying patterns of consumers and the CPI are directly related, which isn’t always the case, however generally-speaking the basket of goods and services compared quarter-on-quarter provides a good indication of the way prices are trending overall within the Australian economy.

When inflation occurs, everyday goods and services such as milk, bread, groceries, fuel, electricity and other utilities, and other services generally see an increase in price.  Currently, a dollar buys only 97% of what it used to 12 months ago.  Our buying power has reduced by 3% thanks to inflation.

Measuring real returns
When assessing rates of return few people take into account inflation, possibly because inflation has been low for many years in Australia. In 1974 however inflation peaked at 16.4%, meaning a significant increase in prices of consumer goods and services occurred at record levels.

The significance for Australian’s seeking a meaningful return on their capital is that real returns should take into account inflation.  For example, a strategy that returns say 5.75% per annum in today’s environment means a real return of 2.75%. (5.75% less 3.0% = 2.75%).

Similarly, a strategy that returns say 2.5% per annum in today’s environment means a real return of -0.5%.  In other words, despite deploying your capital to achieve a 2.5% return, by the time inflation is factored in, your buying power has been eroded by a factor of 0.5%.  Put simply, you’re going backwards.

Now more than ever it is important to identify opportunities that are capital stable and capable of keeping you ahead of inflation.

Popular hedges against inflation
Hedging against inflation is popular with assets that are generally expected to rise as people’s buying power diminishes.  Assets such as gold, commodities more generally, and real estate are typical hedges.  The effectiveness of real estate in Australia might be brought into question as a hedge against inflation given the sharp rises in certain capital cities since COVID-19 took hold.

Generally speaking, the deployment of capital in assets that are capable of generating returns higher than inflation, taking into account risks, can be a good way to ensure your strategy is outpacing inflation. Given the likelihood of sustained inflation on the horizon it is little wonder that alternative assets, such as those offered by TPP Global Investments, are growing in popularity.