What do you mean by inflation?

What do you mean by inflation?

In the last number years, there has been a lot of talk about inflation. Inflation can have a negative effect on your investments but, as usual, it’s not as simple as that and we must take a closer look at it to try and understand what it is, and if it’s always a bad thing for your savings.

Senior Financial Consultant Eoin McKeagney pens an article on inflation and what it means for us going forward.

So, what causes inflation?

Have you ever noticed that prices rise or the size of, say, a bar of chocolate has shrunk over time? Or, have you noticed that the price of fuel on the garage forecourt has risen sharply recently? At the moment, there are numerous examples in your daily shopping basket to drive home that there is something going on with inflation.  Practically everything we buy in our weekly shopping basket has increased in price and the commodities we use in building, for example, have risen sharply of late.

All this comes down to the first principles of economics – supply and demand.  When supply and demand are equal, you get price stability.  There are a similar number of suppliers willing to supply goods at a certain price as there are buyers for those goods. If one supplier in this scenario tried to overcharge for his product, other suppliers would enter the market driving prices down until balance was reached again.  Similarly, if there are few suppliers in a market where there is lots of demand (the Irish Property market, for instance), suppliers can keep pushing the price of the product up because of scarcity.

 COVID19 and inflation

An additional driver of inflation has been the pandemic which disrupted supply chains around the world so that when we began emerging out of the lockdown, global supply lines were disrupted with ships in the wrong place to transport goods to market and the simple lack of goods drove prices up – supply and demand at work again!

Finally, with regard to commodity prices, again disruption has had the effect of eating into reserves for many commodities such as oil, minerals, etc. And this in turn drove prices higher.  That’s why many economists felt that the inflation spike we’re currently enduring would be a ‘temporary blip’ – once supply lines had been restored, prices would return to normal.  However, recent geopolitical upheaval has probably set a lie to this and as long as Russia are in Ukraine, we will have price instability and inflationary pressure on the system.

Interest rates

As you can see from this very basic explanation, there are many factors at play that can have a bearing on inflation.  Traditionally, when a Central Bank saw the appearance of inflation, they used the main gearshift they had to dampen inflation and that has put up interest rates.  In Europe, this is no longer easy to do as the European Central Bank has to take into account almost thirty countries who may be in differing stages of their economic cycle so a move in rates for one, might not be appropriate for another state.

Is inflation always a bad thing? Short answer is no.  A business must understand its pricing model in its own marketplace and sometimes, businesses will reduce their prices to compete against other operators in their business sector.  But such an approach will not work in the longer term and so prices tend to rise over time to satisfy the needs of the business owners and their staff.  The problem with rising inflation is that is can quickly spiral out of control: a worker notices that his buying power has been reduced by inflation and seeks a compensatory wage increase which, in turn, drives the prices up at the factory gate, driving further wage demand increases and very soon we are in an inflationary spiral.

We have just come off a sustained period of economic growth, unseen in the world before.  That, coupled with very low interest rates has led to a massive increase in the prices of assets.  Housing in Ireland is a classic example.  Too many people are chasing too few assets, driving house prices ever further.  It is something similar in world stock markets, bond markets and commodity prices so, in one sense, a correction has long been forecast but hasn’t happened.  This correction is now happening, against the backdrop of the pandemic and now, the Russian invasion of Ukraine.

Some economists believe that we are seeing a fundamental shift in economic activity with the ‘new economy’ of internet-delivered economic activity replacing the old-style manufacturing economies and the disruption caused by this change is contribution to the uncertainty and rises seen in inflation.

What do we do to protect ourselves?

It is a hard held fact in our business that investing is a medium to long term process.  There will always be shocks to the system, whether it’s a one-off event like 9/11 or a politically disastrous event like the war in Ukraine.  Nobody can foretell the future and anyone who claims to know the future outcomes are lying or deluding themselves.  The job of Financial Advisers is to help you develop a plan for the long-term security of you and your loved ones.  We don’t do this with any certainty about the future, but we do extrapolate from your own goals and help you to recognise the main areas that will affect you throughout your working life and, as with any good plan, we will sit down with you regularly and review your own plan in the light of actual experience and adjust accordingly to ensure the validity of your plans over the longer term.

Eoin McKeagney is a Senior Financial Consultant with SYS Group.


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