The basic principle behind inflation is that as the money supply increases, so too does the relative price of goods and services. A common sentiment for children to hold is “why can’t we all be millionaires, then there would be no poor people”, or something to that effect. The answer is inflation. In theory we could all be millionaires, but this would drive up the price of consumer goods to reflect the increase in money supply, essentially balancing out society’s new found wealth.
The above scenario is an example of hyper-inflation, where prices rise in an
exceedingly rapid fashion. In reality, most modern countries with stable, or
fairly stable, economies have an inflation rate in the low single digits. When
using New Zealand
as an example, we have recorded an inflation rate of a little below three
percent since the turn of the century, never veering too far from that mark in
any one year. For the average citizen what this means is that as the amount of New Zealand
currency increases by three percent annually, the price of goods and services
follow in order to keep pace. In essence, you would have to be earning three
percent or more in additional income each year in order to avoid a decrease in
your buying power.
The example of wage parity shares a common connection with how savings are
affected by changes in inflation. Your savings must also increase at the same
rate of inflation each year in order hold their real worth. If prices are
rising annually but your savings remain unchanged, you are able to purchase
less with the same amount as you were the previous year. This is why keeping
your savings hidden under a mattress is not the smartest investment strategy,
even if you ignore the security issues. What the vast majority of us do instead
is deposit our savings into the bank.
Banks have made for sound investments, seeing as the deposit rate has
traditionally been above the inflation rate, at least in New Zealand.
This means that your savings are growing faster than inflation, effectively
increasing the value of your deposit within the marketplace. The problem is,
following an increase in GST, inflation has risen above the interest rates
offered by banks. It is still a far safer investment than storing cash under
your mattress, but not as secure as it once was.
Modern investors need to more carefully consider their options when
structuring a portfolio. Of course the key advantage of a bank is that you
don’t risk losing your investment, but if your value is being eroded from year
to year then you have to ask yourself what the point is. The best thing to do
is speak to an Investment Adviser, who can help sort through your options and
minimise the impact of inflation upon your savings.