This continuation of the getting familiar series is all about inflation: How it works and its effect on your investments.
The next time you are about to place an order for food at a restaurant, consider this: the laminated menu placed in front of you means that prices are relatively stable (the alternative is a new menu is printed at this restaurant everyday or something of a similar nature). If for some reason, prices of the restaurants ingredients are increasing at an alarming pace, the restaurant will continually have to update its prices on the menu to reflect this changes in its cost of raw materials. On a particular day, for instance, ₦2,000 buys you 2 plates of rice at a restaurant. Now lets say you walk into the same restaurant a week later with the same amount (₦2,000) looking to buy 2 plates of rice, only to find you can only buy 1 plate of rice at that price. In this scenario, the strength of your ₦2,000 is considerably weaker. This is exactly what happens in an economy facing rising inflation.
Inflation is the general increase in the average prices in an economy. If there is an increase in the average prices of goods in an economy, the major effects is that it reduces the purchasing power of your money (as illustrated above). An increase in the price of raw materials in an economy could lead to rise in prices of goods and services throughout the economy. For instance. higher taxes are passed on to customers in the form of rising prices. This situation is known as cost-push inflation. The causes of cost-push inflation include the cost of raw materials, labour costs, exchange rates, and indirect taxes.
Another common type of inflation is when there’s too much money in the economy chasing too few goods. This creates what is known as demand-pull inflation. The causes of demand-pull inflation include monetary policy, government spending, lower tax, consumer confidence, property prices, and rapid growth abroad.
Need to Know
| Monetary policy | Actions of a central bank or other committees that determine the size and rate of growth of the money supply, which will affect interest rates. |
| Purchasing power | Purchasing power is the value of a currency in terms of the goods or services that one unit of it can buy. |
| Core inflation | Core inflation is the change in costs of goods and services, but does not include those from the food and energy sectors. |
| Inflation expectations | Rate of inflation that workers, businesses and investors think will prevail in the future, and that they will therefore factor into their decision-making |
| CPI | The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care |
| Nominal value | Prices, wages, and other economic variables that are not adjusted in order to take account of inflation |
How do we measure inflation? Inflation can be measured by using the consumer price index (CPI). The CPI is made up of a basket of goods and services such as household consumption, transportation, and healthcare costs. It is a weighted average measure. The percentage change in the index over a period determines the rate of inflation. i.e. the percentage change is the indicator of whether inflation rose or fell during the period under review.
How do countries manage inflation? The central banks of various countries attempt to control inflation by lowering and raising short-term interest rates. This exercise will then speed up or slow down the level of economic activity. Lowering short-term rates encourages banks to borrow from a central bank and from each other, effectively increasing the money supply within the economy. Banks, in turn, make more loans to businesses and consumers, which stimulates spending and overall economic activity. On the other hand, when the central bank raises short-term rates, it discourages borrowing, decreases the money supply, decelerates economic activity, and subdues inflation.
How does inflation affect investments? Inflation erodes the value of investment returns over time. Even though an increase in inflation weakens purchasing power, some securities are affected more than others. Cash suffers the most in an environment of rising inflation. Furthermore, equities have often been a good investment relative to rising inflation over the very long term. The reason is because companies can raise prices for their products when their costs increase as a result of rising inflation.
On the contrary, rising inflation does not bode well for bonds because the the value of the principal deteriorates. For example; an investor buys a five-year bond with a principal value of ₦10,000. If the rate of inflation is 3% annually, the value of the principal adjusted for inflation will sink to about ₦8,300 over the five-year term of the bond.
Your goal as an investor is to increase your long-term purchasing power. To invest successfully, your investment portfolio should consider expectations around inflation.
Nigeria’s inflation story: In today’s (November 14 2018) news, the World Bank suggested that a further increase of global inflation could negatively impact Nigeria. This increase in global inflation threatens the low inflation environment Nigeria has achieved over the past several decades. An increase in inflation could adversely affect Nigeria’s poor people, because most of their assets are in the form of cash, compared to higher income earners who store their wealth in different forms.
In the month of September 2018, Nigeria’s inflation rose by 0.05% to 11.28%. This mild increase in inflation was driven by the reduced impact of higher food inflation (food inflation rose by 0.15% to 13.31% in September). Also, as Nigeria’s foreign reserves continue to dwindle (the external reserves declined to US$41.7 billion (13/11/2018) from US$47.6 billion at start of the second half of 2018), expect Nigeria’s monetary authorities to continue to sustain the foreign exchange market with its weekly interventions in the short term. However, given the pace of depletion of the reserves, expect to see the Central Bank of Nigeria (CBN) stimulate the economy via monetary policy in the medium to long term.
Key takeaways:
- An increase in the prices of goods and services in an economy, reduces the purchasing power of your money
- This increase in the average level of prices (inflation) is tracked by measuring the consumer price index (CPI) regularly. It is a basket goods and services including food items, transportation and healthcare
- To invest successfully, your investment portfolio should consider expectations around inflation
- If there was no inflation real and nominal inflation would be the same
- The poor suffer from inflation because most of their wealth is in the form of cash, and inflation adversely affects cash
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