Inflation explained simply (and in less than 1,000 words)
We regularly publish short articles aimed at popularizing economic concepts, but there is one topic that we have avoided to date, even though it is crucial for any saver : inflation. Indeed, we would like our articles to be read, and it is challenging, to say the least, to attract readers if a word of this type appears in the title! So three promises upfront: it will be short, we will avoid the use of technical terms wherever possible, and most relevantly, it will a worthwhile read if you want to make money with your money.
What is inflation and how is it calculated?
The INSEE defines inflation as “the loss of purchasing power of money, which occurs through the general and sustainable increase in the prices of goods”. The institute is also responsible for its calculation: every month, its agents register over 200,000 prices for slightly more than a thousand specific goods and services that are considered as being representative of the purchases made by the population. We are talking about the famous “housewife’s shopping basket” (though the official and less sexist term is the Market Basket of French households), the composition of which is adjusted once a year, to take the evolution of what the average household consumes into account. Coffee-pads and MP3 players have thus been added, whilst video cassettes and leaded petrol have been excluded. The exact composition of the list remains secret, in order to avoid the potential manipulation of the inflation rate. Finally, prices are registered in the same shops in 96 different cities, in order to ensure the coherence of the analysis. On the basis of the collected price tags, the INSEE calculates the average change in price on the basket, each product being assessed for its relative importance in the overall consumption. Expressed as a percentage, this rate of change is most often positive - defined as inflation -, and more rarely negative, signalling a reduction in prices, defined as deflation.
OK, great. What is the link between inflation and my savings?
The inflation rate indicates by which percentage prices have increased during a given year (on average). If it equals 2% for example, that means that at the end of the year I will need €102 to purchase what I could have bought for €100 at the start of the year. Consequently, if my money did not earn 2% or more during that same period, my purchasing power will have declined. Indeed, inflation will have reduced my ability to buy goods, as their prices will have increased during the year.
More specifically, in 2018, inflation reached 1.85%. Therefore any money in a current account not earning any interest (which is the case for the current accounts of most French banks) would have lost this percentage in purchasing power. Importantly, the current inflation rate is higher than the interest rate offered on traditional savings accounts (0.10% or 0.15%) or on the Livret A accounts (0.75%). It also exceeds the yield generated on most annuity life insurance contracts, which reached 1.6% on average last year, according to Good Value for Money. Said differently, over and above the “dormant” cash which sits in current accounts and traditional savings accounts (for a total amount in excess of €1000 billion), money which is “put to work” in Livret A accounts and in certain life insurance contracts do not earn enough to compensate for inflation and its negative impact on the purchasing power.
ARGH! Can we eliminate inflation?
Inflation has been very low for a quarter of a century, fluctuating between 0% and 2.8% in France. Which is significantly lower than at the start of the 90’s, when inflation was over 3%, or relative to the start of the 80’s, when it exceeded 10%!
In addition, the stated objective of the central bank policies pursued by the main central banks is to target a regular and modest increase in general prices of goods. The European Central Bank (ECB) has set a target inflation rate for the euro zone of approximately 2% per year. Indeed, a modest rate of inflation has beneficial effects on the overall economy: a low and stable inflation stimulates companies to invest and pushes individuals to invest their money, rather than letting it sit idle on their current accounts. A sustained reduction in inflation to a rate close to zero is therefore highly unlikely.
Understood. But what can I do to preserve my purchasing power?
That’s the right question to ask. Theoretically, the answer is simple: you have to invest the money you do not believe you may need in the immediate future in such a way that it yields at least as much as the inflation rate. Said differently, if the inflation rate is at 2%, savings (after commissions and tax) have to yield at least as much.
It’s in the real world that things get more complicated, as it is not easy to identify that kind of yield without risk, in the current low interest rate environment. The optimal response will therefore vary from one person to another according to different criteria, including the amount of money one has to put to work, the expected investment period, the need to be able to access the funds at any time or not, and the risk appetite of the investing individual. But one thing is certain, inflation, however low, eats into your purchasing power and should therefore be taken into account by all individuals wishing to save.
Clarity on inflation in less than 1,000 words!!
Cashbee’s objective is to put money at your service, to allow you to achieve your financial goals. In order to achieve it, we believe our users have to master key financial concepts, of which inflation is one. We hope to have contributed to that mission in this article. Because, this sentence included, we have reached our 1,000 word limit!