What Is Inflation

Although inflation is an integral part of every economy, it can cause a lot of problems. Too high of an inflation can lead to a decrease in purchasing power, while too low of an inflation can signal problems in economic growth. To maintain a stable and healthy economy, we should seek to preserve an optimal level of inflation. The institution tasked with monitoring inflation and keeping it around its optimal level is called a central bank.

In this blog, we'll explore what causes inflation, how it's measured, and the best ways to protect yourself against its effects. By understanding inflation and its causes, you will be better prepared to make informed financial decisions in your everyday life.

What Causes Inflation

Inflation, as defined on Wikipedia, refers to a market economy where the prices of goods and services are constantly changing - some prices rise, while others fall. However, inflation refers to an increase in the general price level, not just changes in the prices of individual products.

As a result of inflation, the value of money declines over time; this means that the same amount of money can buy you fewer goods and services today than in the past. Inflation, therefore, reduces the purchasing power of an economy's currency, which has a significant impact on the lives of its citizens.

Imagine two people: one who earns 1500 € per month and another who earns 1200 € per month. Let's see how an average inflation rate of 3% affects their purchasing power.

• Year 1: The person earns 1500 € per month.
• Year 2: Prices have increased by 3 %.

Suppose the person spends 1000 € per month on necessities (food, rent, utilities, etc.).

• In Year 1, with 1000 €, they can buy a certain amount of goods and services.
• In Year 2, due to 3% inflation, those same goods and services will cost 1030 € (1000 € * 1.03).

If their income remains the same, at 1500 €, they will have 30 € less to spend or save each month, after covering their necessities. This 30-euro difference represents a reduction in their purchasing power.

Now, let's consider another person who earns 1200 € per month.

• Year 1: The person earns 1200 €.
• Year 2: Prices have increased by 3 %.

Let's say this person spends 1200 € on necessities:

• In Year 1, with 1200 €, they can buy a certain amount of goods and services.
• In Year 2, due to 3% inflation, those same goods and services will cost 1236 €.

With an unchanged income of 1200 €, this person cannot afford to buy the same basket of goods and services as they could a year before. That’s why they must reduce their volume of consumption.

Inflation affects everyone, but its impact can be more significant for those with lower incomes. As the cost of living rises, people's ability to afford goods and services decreases unless their income rises at the same rate or faster than inflation.

This is a simplified definition of inflation. However, the situation is a little more complicated, so we will consider it in more detail step by step. There are several key causes that can lead to inflation:

Increase in the Money Supply

• Printing more money: When a central bank creates more money, its amount in circulation increases without a corresponding increase in the number of goods and services that can be produced (as the productivity of companies, at least in the short run, is unaffected by the amount of money in circulation). This results in higher prices as more money chases the same number of products. For example, during the pandemic, subsidies and direct payments to individuals increased money supply and spending, contributing to inflation.
• Currency devaluation: When a government devalues its currency, imported goods become more expensive, leading to higher overall prices. This reduces purchasing power and causes inflation.
• Borrowing through the banking system: Banks giving out more loans results in increasing spending and investment. If consumption grows faster than production, prices rise due to higher demand.

Demand-Side Factors

• Growing income: As incomes rise, people spend more, increasing demand for goods and services. If supply doesn't keep pace, prices go up, causing demand-pull inflation. This type of inflation happens when aggregate demand in the economy exceeds its aggregate supply.

Supply-Side Factors

• Supply bottlenecks: Disruptions in production or distribution can create shortages, driving up prices. For instance, pandemic-related supply chain issues and the Suez Canal blockage in 2021 caused significant price increases. This can lead to cost-push inflation, where overall price levels rise due to increased production costs.
• Shortages of key goods: Lack of essential raw materials or energy can increase production costs, which are passed on to consumers through higher prices, leading to cost-push inflation.

Built-In Inflation

• Also known as "wage-price inflation," this occurs when expectations of future inflation drive current inflation. If people expect prices to rise, they demand higher wages, which leads businesses to increase prices, creating a cycle. This type of inflation is driven by the interaction between wages and prices and can perpetuate the inflationary cycle.

How Inflation Affects Our Pockets

Inflation affects many aspects of our economic life, such as spending, saving, investing, and borrowing. To understand how inflation works, we need to follow price indexes and analyze concrete examples of its effects.

How is inflation measured?

The Consumer Price Index (CPI) measures the change in the cost of a basket of goods and services that the average household buys for its income.

It is a crucial indicator of inflation, reflecting how much the cost of living is increasing. For example, if the CPI rises by 3 %, it means that, on average, prices have increased by 3%, which reduces our purchasing power. According to TradingEconomics data, the average annual inflation in Croatia from 1999 to 2024 was 2.73 %.

The CPI is calculated by taking a sample basket of goods and services that are typically purchased by households. This basket includes categories such as food, housing, clothing, transportation, and healthcare. The prices of these items are tracked over time to determine the overall rate of inflation.

However, it's important to note that everyone experiences individual inflation based on their unique consumption patterns. For instance, if someone spends a larger portion of their income on healthcare, and healthcare costs rise sharply, their personal inflation rate may be higher than the average CPI. Conversely, someone who spends more on electronics, which may have falling prices, could experience a lower personal inflation rate.

Here's an example of what the CPI basket might look like, focusing on the biggest categories:

• Housing: This includes rent, utilities, and maintenance costs.
• Food and beverages: This covers groceries and dining out.
• Transportation: This includes the cost of buying vehicles, fuel, and public transportation.
• Medical care: This covers health insurance, medical services, and prescription drugs.

To better understand the impact of inflation, let's take a look at the price of your favorite morning beverage - coffee. In Croatia, 3.8 kilograms of coffee are consumed per person per year, which places us in the 15th place in the world in terms of coffee consumption, according to the data from the World of Statistics.

In 15 countries of the European Union, coffee inflation in March of this year was higher than in the same period last year. The highest inflation was recorded in Croatia, where it amounted to 7.4%. The price of the raw material, of course, affects the price of a cup of coffee, which today is around €2 (of course it depends on the location and the type of coffee place).

Source: Investopedia

Positive and Negative Effects of Inflation

Consumption

• Negative: When inflation is high, our money doesn't go as far as it used to. For example, last year you might have bought a week's worth of groceries for 100 €, but now the same groceries cost 120 €. This makes you reconsider what you put in your cart, maybe skipping the brand-name items for store brands or buying fewer snacks.
• Positive: On the flip side, if inflation is moderate, you might decide to buy that new phone or appliance now rather than later. For instance, if you know that the price of a laptop is likely to go up by 5 % in the next few months, you might buy it now to save money.

Savings

• Negative: High inflation reduces the real value of your savings. Imagine you have 5,000 € in your savings account. If inflation is at 10 %, next year your 5,000 € will only buy what 4,500 € could buy today. This makes it feel like your hard-earned savings are shrinking.
• Positive: With moderate inflation, you might be more inclined to invest your money rather than keeping it in a low-interest savings account. For example, instead of leaving 1,000 € in a savings account earning 1 % interest, you might invest it in stocks or mutual funds that could potentially earn 5-7 %, helping your money grow faster than inflation.

Real Income

• Negative: If your salary doesn’t keep up the pace with the inflation, your real income drops. For example, if you get a 2 % raise but inflation is 4 %, you’re effectively losing purchasing power. This could mean cutting back on dining out or entertainment because your paycheck doesn't cover as much as it used to.
• Positive: However, if your wage rises faster than the inflation, your purchasing power increases. Suppose you get a 5 % raise while inflation is only 2%. This means you have more money to spend or save, making it easier to afford things like a nicer car or a vacation.

Credits

• Negative: Lenders lose out if inflation is higher than the interest rates on loans. For instance, if you lend a friend a 1,000 € at a 3 % interest rate, but inflation is 4 %, the money they repay is worth less than when you lent it. This makes lending less attractive.
• Positive: Borrowers benefit from this scenario. If you took out a student loan with a 4 % interest rate and inflation rises to 6 %, the money you repay is worth less than when you borrowed it. This means your debt is easier to manage over time, making it feel like you’re repaying less in real terms. All borrowers taking loans with low interest rates a couple of years ago experienced this inflation benefit in recent period of high inflation.

Assets

• Negative: Fixed-income assets like bonds lose value during inflation. If you own a bond that pays a fixed interest rate of 3 % but inflation is 5 %, your returns are effectively negative in real terms. This can make bonds less attractive compared to other asset classes.
• Positive: Tangible assets, such as real estate, tend to go up in value with inflation. If you own a home, its value might increase along with inflation. For example, if your house was worth 200,000 € last year and inflation is 5 %, this year it could be worth 210,000 €. This helps protect your wealth and even grow it.

Inflation can significantly affect our spending, savings, real income, credit and assets. Whether the impact of inflation is positive or negative often depends on broader economic conditions and our personal circumstances.

Source: Napkin Finance

Why was inflation so high in recent years

Inflation rose to the highest levels since the early 1980s in 2022, driven by a combination of global disruptions and policy responses. The pandemic has played a central role in this economic upheaval, causing significant disruption to global supply chains, including widespread factory closures and severe port bottlenecks. These interruptions made efficient production and distribution of goods difficult.

In response to these challenges, governments around the world issued stimulus checks and increased unemployment benefits to support individuals and businesses in financial difficulties. The world experienced suppressed supply on the one hand and boosted demand from stimuli on the other hand resulting in double digit price growth.

The situation was further complicated by geopolitical tensions. In early 2022, Russia's invasion of Ukraine led to a series of economic sanctions and trade restrictions that significantly affected global markets. One of the main consequences was the decrease in the global supply of oil and gas, which contributed to the rise in energy prices. In addition, the conflict has disrupted Ukraine's ability to export grain, leading to sharp increases in food prices.

These rising fuel and food costs have had a ripple effect throughout the economy, raising prices across various value chains. Increased energy and food costs have translated into higher prices for many other goods and services.

In the fight against high inflation, the Federal Reserve and the European Central Bank (ECB) implemented aggressive monetary policy measures, including interest rate hikes. These actions helped to reduce inflation significantly by 2023. However, despite these efforts, inflation remained elevated compared to pre-pandemic levels, reflecting ongoing economic pressures from the disruptions of previous years.

How to protect your finances against inflation

Protecting your finances during inflation requires a thoughtful and comprehensive approach. To hedge against inflation and preserve your wealth, it's important to understand how different strategies and asset classes can help combat inflationary pressures. We will write more about that topic in upcoming blogs.

One of the effective ways to protect against inflation is investing in assets. Firms that have strong pricing power can adjust the prices of their products and services to match rising costs caused by inflation. This ability to adjust can help them increase revenues and potentially improve profits, especially in the initial stages of inflation. Also, companies that own significant physical or financial assets can benefit from inflation as the nominal value of those assets increases. This can lead to an increase in the overall value of the company, which in turn can increase the price of their shares.

However, inflation can also bring challenges for companies. If the costs of raw materials, labor and other inputs rise, and companies cannot fully pass those costs on to consumers, profit margins can shrink. In addition, if inflation persists for a long period of time, the purchasing power of consumers may decline, which may lead to reduced demand for goods and services. Companies in cyclical sectors, which are more sensitive to economic changes, may see a slowdown in sales when consumers cut back on their spending.

Despite these challenges, stocks are often a strong hedge against inflation. Historically, the markets have provided returns that beat inflation rates, helping investors preserve and even increase their purchasing power over long periods of time. Also, some sectors and companies are better suited to manage inflation. For example, consumer staples companies often have steady demand for their products, making them more resilient to inflationary pressures.

Diversification also plays an extremely important role in protection against inflation. Instead of focusing on just a few securities or limiting your investments to one type of asset, it is advisable to build a diversified portfolio with a wide range of securities and assets. Such an approach protects your wealth because, when one investment does not achieve the expected result, others can compensate for the losses.

Ultimately, successfully protecting your finances during inflation requires careful planning and strategic investment. Understanding how different types of assets react to inflation and diversifying your portfolio can help you preserve and potentially grow your wealth in times of economic uncertainty.