What is inflation and how does it work?

What is inflation?

What causes inflation?

Inflation can be triggered by a number of different things, but the current inflation surge is being driven by two main factors: The fallout from the pandemic and the invasion of Ukraine by Russia.  

When the pandemic triggered lockdowns around the world, governments reacted by injecting billions into their economies, the majority of which was given to households and individuals.

This was to make sure that people could continue to make ends meet, but also to ensure that economies were able to continue to function.  

When lockdowns ended, this extra stimulus money was spent, meaning that while many industries weren’t able to operate as normal due to lockdowns and restrictions elsewhere in the world, there were very high levels of demand for products that couldn’t be produced as quickly or as cheaply.

This has led to an increase in prices for many popular consumer goods. 

However, the sharpest increase in inflation has been triggered by Russia’s invasion of Ukraine, and the subsequent decision by many governments around the world to stop using Russian oil.

Due to the added costs of finding new energy sources from elsewhere, using oil has become much more expensive.  

What are the effects of inflation?

Inflation has an immediate impact on both households and businesses.

With people having to spend more on their daily essentials, it becomes harder and harder for people to maintain their current living standards.

Inflation also affects people’s finances in that, as inflation increases, interest rates may also rise, meaning that people will have to pay back more on their mortgages and loans.  

Inflation is also bad news for savers. With consumer goods and mortgages suddenly becoming more expensive, the money you’ve saved won’t be worth as much as it was when you started saving.

In real time, inflation erodes your cash savings and can make it harder to reach your financial goals.  

The same impacts are felt by businesses too. With costs increasing, businesses exposed to higher levels of inflation throughout their supply chains have little choice but to raise the costs of their goods and services, potentially pricing out their customers and clients.

In extreme cases, rising costs can even force some businesses to close as it becomes impossible to operate at such reduced margins.  

Historic inflation levels

Part of the reason why current levels of inflation in the US and Europe are having such a profound impact is that such spikes in prices haven’t happened in a long time.

The inflation peak in June of 9.1 per cent was the highest level since 1980, when a global oil crisis pushed the inflation rate in the US to 13.5 per cent.

This crisis would eventually push the economy into a recession, once a number of interest rate rises stopped people spending much of their income.  

But even the oil and inflation crisis in the 1980s wasn’t as serious as the levels seen just after World War Two and in the 1920s.

Both taking place just after world wars, these inflationary periods were triggered by the rapid ending of wartime restrictions, such as rationing, price controls and the overwhelming level of consumer demand that rushed into the economy.

In 1920, the inflation rate hit 15.61 per cent, while in 1947, inflation topped 20 per cent.  

While there’s little chance inflation will rise to these historic levels, the current inflation rate remains unusually high.

Fortunately, it’s not expected to remain at these highs for a long period of time. The Federal Reserve is already raising interest rates, meaning that inflation will eventually start to cool.

Current forecasts suggest that by the end of 2023, the inflation rate should have returned to a more normal level of around three to four per cent.  

How do you calculate the inflation rate?

There are different ways of calculating interest, which is why the exact level of inflation can differ slightly depending on which method is used.

The federal government uses two main inflation indexes to keep track of prices: The Consumer Price Index (CPI) and the Personal Consumption Expenditures Index (PCE).  

The CPI is calculated by assessing the price changes in popular household expenditures and measuring them against its historical price level.

However, the CPI doesn’t include things that households don’t spend directly, such as government-assisted schemes like Medicaid and Medicare.

The PCE does include these things, meaning that this index generally produces more of a median inflation rate, as opposed to the CPI which can produce slightly higher levels.  

How to prepare for inflation

Inflation effects everyone, but there are some steps you can take to protect your finances:  

• Postpone major purchases: Inflation means your money will be worth less going forward, so spending a lot of money on large purchases will burn a larger than usual hole in your finances 

• Switch to fixed-rate loans: From mortgages to auto finance to credit cards, being on a variable-rate policy during an inflationary cycle can create problems if interest rates start to rise. If possible, try to refinance onto a fixed-rate policy or consider moving your money onto fixed-rate credit cards 

• Pay off existing debt: If you have outstanding debts, you could find yourself having to pay back more money once inflation kicks in. Paying off your debts stops them from becoming a bigger problem further down the line 

• Consider investing: During inflation, cash loses some of its value. However, there are a range of different financial products and investments you could spend your loose change on that could return more money further down the line, even above the inflation rate 

• Consider getting an annuity: If you’re approaching retirement, and your plans will be affected by inflation, you may be able to buy an annuity that guarantees you a set level of income to retire on, and these can often be at an above-inflation level. However, be sure to take on the right financial advice to make sure it’s the best value option for you. 

Inflation has an impact on everyone, but with the right financial knowhow and expertise, you can manage the price increases that will affect you the most.

If you found this article useful, you might also find our latest piece on the slowing of inflation informative, too.