So what is inflation? It refers to the increase in the price of goods or services over time, in other words the loss of real value per unit of money. This measure can be calculated on an individual good or service, a particular segment of the economy (for example health services) or a representative basket of goods and services which is how the Consumer Price Index (CPI) is calculated.

Positive impacts

While inflation often has negative connotations as it can increase the opportunity cost of money, discourage saving and ultimately lead to higher interest rates, there can be positive impacts too. These include encouraging consumers to spend and business to undertake capital expenditure, reducing the real cost of debt and enabling central bank policy by keeping nominal interest rates above zero so central banks can reduce interest rates when required.

There is some debate amongst economists around the causes of inflation which include changes in the real demand for or supply of goods and services, changes in real wages and the growth of money supply outstripping growth in the economy.

In most developed markets it has been a relatively long time since economies have faced the challenge of high inflation and the problems it presents. Is this about to change?

Post the GFC, despite massive central bank stimulus that resulted in money supply growing significantly faster than the slowly recovering global economy, inflation has remained benign. There have in fact even been fears of deflation , particularly in Europe, much to the surprise of many investors. One possible reason for this is that the velocity of money (i.e. how frequently and quickly it changes hands in the economy) has remained low as a lack of business and individual confidence drove a preference for debt reduction and capital consolidation rather than business investment and consumer spending.

But what is the likely outcome when increased confidence and economic activity return?

As is currently being debated by the US Federal Reserve Bank, it will be necessary to remove excess money supply and raise interest rates. It is however politically easier to cut interest rates and stimulate the economy than to raise interest rates – some policy makers have indicated a willingness to err on the side of leaving expansionary monetary conditions in place longer than required rather than raising rates to a more neutral setting too early and risk another recession. Such inaction could lead to inflation increasing more than currently expected in the years ahead.

So who loses from inflation?

First and foremost savers and lenders that lock in rates where the interest payments received do not adjust for the loss of real purchasing power (i.e. holders of term deposits and fixed rate bonds).

And who wins?

Conversely, borrowers – individual, corporate and government – benefit because the nominal amount repaid in the future (equal to the amount borrowed today), has less real purchasing power when prices are steadily rising. Holders of “inflation hedged” assets such as toll roads or health insurers that are able to increase their revenues in-line with or even above inflation are also winners. So too are investors in companies that due to their market dominance or the essential nature of the product being sold, are able to consistently increase their prices.

• Are you an investor relying on your assets to support your lifestyle?
• Do you understand the consequences of the changing economic landscape?
• Are your investment strategies suitable to protect you against lower future living standards?

If you would like to find out more, call our experienced team on 1300 ELSTON or email info@elston.com.au and we will have an adviser contact you.