At the level of everyday life, we interpret the term “inflation” to mean that “everything is getting more expensive”. But if we want to figure out specifically what is behind this term and how inflation affects security for your savings and what are the ways to protect yourself from inflation, then this article might prove useful.

First off, there are two kinds of inflation: monetary and price inflation. Monetary inflation is when a country’s economy receives more money than it did before. It’s the Central Bank that takes care of that, and it has no effect on our savings.

The thing that we should really be worried about is price inflation. It manifests itself in the fact that today you can buy more products and services than you can purchase for the same amount of money, for example, in a year.

Let’s say you come into a grocery store to buy your favorite frozen pizza. It costs 4 dollars. And then, it dawns on you that you need to put things in perspective and take care of your future self; to this end, you refuse to purchase that pizza, and instead, carry your money saved to a bank and deposit it into your account.

You’re sure that a few years later, you’ll withdraw the money from your account, go grocery shopping and buy the very same pizza with enough left over for, let’s say, a bottle of lemonade.
 

But unfortunately it doesn’t work like that

In reality, after several years, you get your 4 dollars back, plus you receive interest from your deposit. In total, you will have, for example, 5 dollars at your disposal (depending on an interest rate and the term of the deposit).

You go to the store, come to a food counter and see that your favorite pizza now costs 7 dollars. Not only do you have to dispense with the lemonade, but you also can’t afford the pizza itself. Price inflation has eaten your pizza and drunk an entire bottle of lemonade over that time!
 

Consumer Price Index

Of course, it’s not correct to assess inflation by the only one item. That’s why official inflation is calculated using a large set of goods and services. This set as well as the method of inflation calculation is called Consumer Price Indices (CPI). This indicator is expressed in percentage terms and shows the price change of a consumer basket (a set of goods and services consumed by an average household) for a certain time period.

The CPI calculation is normally carried out by the National Statistics Office (Service) of a country.

Roughly speaking, the representatives of the National Statistics Office go to the marketplace and purchase a basket of certain goods. The basket costs, let’s say, 30 dollars. Exactly one year later, they go back to the same marketplace and buy the same set of goods. It turns out that the total cost is now 33 dollars. It means that the price for the basket increased by 10%, that is, the annual inflation rate amounts to 10%.

To calculate the CPI, the Statistics Service monitors the price of a wide range of goods and services, including red caviar, marker pens, tarpaper and even funeral expenses.

Everyone has his own inflation rate

If, for example, the National Statistics Office of your country estimates that the annual average consumer price inflation rate has accounted for 10% over the last few years, and your pizza has gone up by 75% over the same period, then it becomes clear that the figures don’t add up.

The reason for this is that inflation is varied. Some products and services may grow in price faster than the others. That’s why every person has his or her individual inflation rate, which depends on what products they normally purchase.

Thus, the official inflation rate is an average figure, which reflects your situation insofar as you are close to the average citizen of your country.

Real return

Clearly, no one wants to lose their money to inflation, so many of us are looking for ways to protect our savings from this scourge. Hopefully, these ways do exist.

The easiest way to protect your money from inflation is to put it in the bank. You give your savings to this financial institution for a certain period, and after a while the bank gives your money back with interest.

However, even if the sum on your account has increased over that time, it doesn’t mean that you have got any profits. For example, if the inflation rate is higher than the deposit interest rate, even though your account balance is increasing, you are losing your money, because its purchasing power is diminishing fast.

If the inflation rate is lower than the deposit interest rate, then you do make a profit.

Profitableness adjusted for inflation is called real return. For example, you have made a deposit at an effective interest rate of 10%. The annual inflation rate has accounted for 5.4%, and consequently the real return on your deposit has amounted to 4.6%.
In case the real return is negative, you lose your money, but when it is positive, you make money.

However, you should bear in mind that the real return is profitableness corrected to the official inflation rate, rather than your individual one. That’s why the more you are different from an average citizen of your country in terms of a set of goods and services consumed, the harder it is to figure out what is the real profitability of your investments.

Fixed-income bonds and inflation-indexed bonds

If you have already heard about government bonds, you probably already know about fixed-rate bonds with coupons. For example, if you buy a fixed-rate bond with a face value of 20$, this is precisely the sum you’ll get on maturity. And throughout the period from the time of purchase to maturity you’ll receive coupon payments at a fixed percentage of the value of the bond.

Thus, fixed-rate bonds are not much different from ordinary bank deposit, so they don’t really protect your savings from inflation.

However, inflation-indexed bonds are a whole different story. The inflation-indexed (inflation-linked) bonds are one of exotic but efficient tools for protection against inflation.

The main feature of the inflation-linked bonds is that the face value of a bond is indexed to the official inflation rate, that is, CPI.

It’s like the wage indexing of civil servants in many countries: in case their salary accounts for, let’s say, 1000$, and the annual inflation rate amounts to 5.4%, then the indexed salary turns into 1054$.

The inflation-indexed bonds work in a similar fashion. For example, you buy such a bond for 1000$. On the date of maturity, a bond issuer will give you back the inflation-indexed sum (but not less than 1000$, even if the inflation rate has been negative), rather than 1000$ that you paid for your bond.

That is to say, the purchasing power of a loan that you grant to a bond issuer is being maintained over the period to maturity, because it increases by the consumer inflation rate.

As a rule, the indexation of the face value of a bond is carried out daily, but with a delay of several months.

It’s also worth mentioning the coupon interest rate. This rate is normally set at a percentage that is 3-4 times lower than that of bonds not indexed to inflation.

However, the point is that the indexation of the face value of a bond already maintains the purchasing power of a bond’s principal sum, and you don’t need to maintain it at the expense of high interest rate. With regard to a coupon, it is paid as a percentage of the indexed faced value.

That’s why everything you get in the form of a coupon is real return that is higher than the level of inflation.

In view of the foregoing, it might seem that all your attempts to save and accumulate your funds are useless or ineffective, because even inflation-indexed bonds give quite a low return on investments.

But when you get right down to it, it’s really not that bad. It’s ok to be affected by inflation. It is a normal occurrence that has always been around and always will be.

Nevertheless, a man doesn’t stand still, either. We evolve, gain experience, create new technologies and reduce the costs of production. Today we can purchase more gigabyte, gigahertz and kilocalories than we could 20 years ago.

We live longer and our houses are warmer than they used to be 100 years ago. On the whole, our lives have improved, so inflation is not the worst thing that happens in the world. All we can do is diversify investment risk, create added value and contribute to progress. That way we can outrun inflation with enough left over for a pizza.

Source: https://www.robomarkets.com
 

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