Oran Hall | How inflation affects personal money decisions

Inflation, being the sustained and broad increase in the prices of goods and services over time, causes money to lose its real value and thus has a direct impact on people’s lives.

It affects spending, savings and investing decisions, makes it challenging for people to preserve their financial position and how they live, and threatens their ability to achieve their life goals.

When prices increase, purchasing power decreases: the power of a single unit of currency, a dollar, for example, does not go as far as it did before. If income does not increase to match the decline in the value of the currency, the consumer may have to make decisions which may lead to a reduction in saving or investing to compensate for spending more, or, alternatively, reduce the quantity of goods and services purchased.

The challenge the consumer faces is whether to sacrifice living standards or face the consequences of maintaining the standard of living as the cost of living increases by encroaching on funds saved and invested for the future.

In terms of spending, consumers may choose to spend less overall by buying reduced quantities or foregoing some items, find cheaper substitutes, produce some of the items they consume, and pool with others to benefit from volume discounts. They may also become more astute shoppers by shopping around more to be better able to get the best deals. Consumers who choose to buy the same quantities as before may choose to encroach on their savings or investments, or borrow to meet the short fall, and some may choose to find additional sources of income.

Consumers may also re-align their spending. They may opt to reduce or eliminate spending on discretionary items like entertainment. They may choose to manage variable expenses like electricity more carefully, but there is generally little room to manoeuvre for fixed expenses like rent and mortgage. Priority has to be given, nonetheless, to the expenses that are necessary to maintain the basic lifestyle, for example, food and accommodation – the former being variable and the latter fixed.

Inflation can inflict heavy blows on savings in two ways. First, when more is spent on consumption, there is less to save. Second, inflation reduces the real value of savings and that of the interest earned even without the nominal rate of interest falling. The nominal rate of interest on savings accounts and interest-bearing instruments like bonds is the stated rate. The real rate is the nominal rate minus the inflation rate – the real rate is the rate adjusted for inflation. To be better off, if the inflation rate is 5 per cent, the saver or investor must earn more than 5 per cent to get a real return.

The people at greatest risk of being hurt by inflation when real interest rates are negative are people on fixed incomes, for example, pensioners, as well as people who do not have the capacity to increase their employment income and, thus, their savings.

Inflation impacts investments. In the case of fixed-income instruments, not only is it a threat to the real value of the interest earned and the principal which is repaid at maturity at face value, it may cause the capital values of these instruments to fall, as a common tool employed to fight inflation is higher interest rates. When interest rates increase, the price of fixed-rate bonds falls, so investors who sell prior to maturity run the risk of losing some of their principal because of their lower price. The holders of bonds bearing low interest rates are hit the hardest.

Two means of protection are buying variable rate instruments – which pay a rate in line with current rates as they rise and maintain their capital values, and investing in shorter term issues as interest rates increase to gain therefrom. Then, when interest rates settle, switching to longer-term instruments can become an option.

Investment instruments that increase in value over time are generally good hedges against inflation, for example, equities and real estate. Stock prices tend to increase faster than inflation over the long term, fluctuation in their prices notwithstanding. Real estate is also a good beneficiary of inflation from price appreciation and higher rent. Investors who do not have the means to invest directly in it may opt for real estate investment funds.

People who have a leaning to debt can benefit from rising inflation. Based on the principle that principal and interest lose value in real terms because of inflation, the money repaid to lenders is worth less to them in real terms over time, although they receive the same sum in money terms each time they receive a payment from the borrower.

Because inflation causes money to lose value, and thus purchasing power, people risk experiencing a decline in their standard of living and may find it more challenging to realise their financial goals. Although it may be necessary to make lifestyle changes to cope, it is not prudent to abandon existing savings and investment programmes.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com