Inflation

Inflation is a phenomenon where there is too much money chasing after too few goods. (There are of course different types of inflation, but we are not delving into that). Essentially, it is a case where prices increase over time. MAS provides some insight into what inflation is and why it is important to understand it.

In Singapore, core inflation for 2019 stood at about 1%[1], while 2020 data is not out at time of writing, the projected rate for 2020 is between -0.5% and 0%. As a side note, negative inflation is different from deflation. Deflation is a serious economic crisis, indicating serious problems facing the economy.

For illustration, the author remembers when he was a child a short time ago, bus fare for students was 45 cents flat. Today, it has increased, up to 63 cents. Some of our parents may recall HDB flats were priced from $15,000 to $30,000 in 1970s. Today, that would probably not be enough to renovate a toilet.

It is good to note that inflation means a GENERAL and SUSTAINED increase in prices. That means that while recently COE prices have shot up, this is not inflationary yet because a. it is only for one good (transport) and b. because it isn’t (as yet) become sustained. So, to determine if inflation happens, everything must become more expensive.

The critical question would be, how does inflation affect you? If there is inflation, it will mean that prices go up and things will cost more in the future. It means you will need more income tomorrow to maintain your standard of living. By extension, that will mean that $1 today is worth a lot less tomorrow. It means that your lifestyle today will cost you more, in absolute terms, when you retire several years later. For example, since 1989 to 2019, the inflation rate has hovered at about 1.68% per year. This has led the CPI to increase by almost 65% since 1989[2].

To put it into perspective, assume our 30-year inflation rate remains at 1.68%. If your Kopi Gau Siu Dai costs $1 today, it will cost you $1.65 in about 30 years’ time. Now that doesn’t seem much. In fact, it seems reasonable. And it is reasonable, compared to inflation rates in other countries[3]. But if we consider a larger amount, assuming you are living on $500 a month today, you will need $824.40 a month in 30 years’ time. Or, nearly $3,900 a year more just to ensure your living standards do not fall.

The western version of Kopi Gau Siu Dai

So inflation erodes the value of money. You’ll need more money every month just to survive. Inflation also erodes the value of your saving. That means that you need to consider what would happen to your savings that you set aside diligently every month, but do not do anything.

If for example you saved $500 a month, but did not invest it and simply let it into a bank account earning 1%. In financial speak, while you are earning an interest of 1%, your inflation of 1.68% means you have a negative real return, or the value of your savings is actually eroding. For example, your savings of $500 would become $505 after one year. A tidy sum for not doing much. But because of inflation, the $505 wouldn’t be able to buy the same amount of goods. In fact, if you wanted to buy the equivalent of $500 worth of goods in year 1, you will need $508.40 in year 2, assuming an inflation rate of 1.68%. Unfortunately, your savings account only has $505. This is what we might term, a fall in real value.

Hence while saving is good, it is merely the first step towards growing your money. Don’t get me wrong. Saving is definitely a good step. A necessary step even. But it is not the final or only step. You will need to invest and grow your money, otherwise, inflation will erode it.

Of course, all this analysis assumes prices rise. It assumes that inflation is the norm, rather than an exception. Is it possible that prices fall? Yes. But deflation is far worse and harder to get out of. Some level of increase in prices is generally ok. It spurs people and firms to work harder in order to create more value. Deflation, especially if it is prolonged, has severe implications for an economy. Famous cases of deflation include Japan, which had deflation for nearly 2 decades, and during the Great Depression for many countries. But by and large, deflation[4] is quite uncommon. Governments tend to intervene actively to correct deflation (as well as high inflation). Historically, we have longer and more periods of inflationary pressures compared to deflationary pressures. Singapore has had only 5 years of price falls over the last 30 years.

Deflation is sad

So, if inflation is bad for our savings and raises the cost of living, is it a bad thing? Not necessarily. For one, if prices are rising, people are more willing to invest to grow their funds (to beat inflation). If prices were not rising, or worse, deflation, investment will become less attractive and the country can’t grow. It also means there is a certain degree of growth, thus suggesting that the economy is in a good shape. This attracts more growth. Compared to stagnant or deflationary cycles, firms may not be willing to invest, resulting in more problems moving forward.

That said, high rates of inflation are very harmful. That makes it difficult to estimate future prices, and hence, investment rates of return will be harder to determine. Just for fun, make a guess as to what was the highest rate of inflation ever recorded.

Nope. You are wrong by a few zeroes. At least.

The record goes to Hungary back in 1946. At its height, inflation was 195% per day! Quite literally, your $1.20 Kopi Gau Siu Dai would quadruple to $4.80 by the next day. In fact, the annualised rate would have been 13,600,000,000,000,000%. That is 13,600 followed by 12 zeroes. Imagine the notes you had to bring around (the largest denomination note was 100,000,000,000,000,000,000, or 100 followed by 18 zeroes.)

Of course, these are extremely rare situations and the solutions are drastic. The impact on the economy is also disastrous. Happily, Singapore and most of the world, for most part of history, doesn’t face such threats. But that is not to say it could not happen.

So, how can financial planning protect your wealth against inflation? Your first thought should be, investment. But truthfully, that is just one small part.

Financial planning helps protect your wealth by projecting your needs. A competent financial planner will be able to account for inflation to ensure your plans remain appropriate. Lets consider retirement. Understanding inflation, we’d know to adjust our future needs accounting for a projected inflation rate. We have seen earlier that $500 today is worth $824.40 in 30 years assuming an inflation rate of 1.8%. So we know that our target savings amount must be able to provide $824.40 a month for as long as we live.

But it is not just for retirement. In calculating education needs for example, we should look at education inflation, which could be higher (in fact, it is higher). When calculating healthcare needs, one should recognise that with aging population and with better healthcare, the healthcare inflation rate is higher than the average inflation rate (which it is).

Understanding inflation also means that investment returns can be seen in proper light. If you were told that the inflation rate was 6%, you’d know that any investment return less than 6%[5] wouldn’t cut it. It would lead to you losing money.

Inflation is an everywhere phenomenon. In fact, since it is prevalent throughout time and space, it shouldn’t be called a phenomenon, but a reality. And if it is a reality, plans need to account for its impact.

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[1] There are multiple ways of calculating inflation; cpi, core inflation, all items inflation, deflator. Hwere we look at the effects of rising prices, rather than precisely how much do prices rise.

[2] There are different ways of measuring inflation, CPI is just one of the ways. It is also good to note that certain items will have a higher inflation. Healthcare for example had an inflation rate of about 10% in 2018

[3] India for example has inflation rates of above 5% per year more often than not in the last 30 years.

[4] Another common concept is disinflation, which is a situation of falling inflation. In this case, prices are rising slower than it did. There is still inflation, it is just falling. This is vastly different from deflation which is a case of prices falling.

[5] The real calculation is a bit more complicated but for now, the idea will do.