Understanding the Factors that Impact Inflation
A good understanding of the factors that impact the inflation rate helps investors to better plan their investments.
Inflation is defined as a sustained increase in the general price level of goods and services in an economy over a period of time. When inflation rises, the purchasing power of money is reduced as consumers will need to fork out more money to buy the same quantity of goods and services.
For investors, rising inflation impacts the real returns on investments. If the returns on investments do not match or outpace the annual inflation rate, the investments will effectively be losing value in real terms. The real rate of return can be estimated as the nominal investment return minus the inflation rate.
Real Investment Return = Nominal Investment Return – Inflation Rate
The consumer price index (CPI), which measures changes in prices of consumer goods and services, is used to gauge the level of inflation. The CPI typically calculates the cost of a ‘basket’ of goods and services purchased by consumers. As can be seen in Table 1, the main components of Malaysia’s CPI comprise food and non-alcoholic beverages, housing and utilities, transportation and other items.
Table 1: Components of the Malaysian Consumer Price Index
Food & non-alcoholic beverages
Housing and utilities (water, electricity, gas & other fuels)
*Includes clothing & footwear, furnishings, household equipment & routine household maintenance, healthcare, communications, recreation services & culture, education, restaurants & hotels, and miscellaneous goods & services.
However, for a consumer, depending on his or her consumption pattern, the actual rate of inflation that he or she experiences may be different from the official inflation rate as measured by the CPI. For example, as prices of groceries and dining-out expenses have been rising at a faster pace than the headline inflation rate over the years, an individual who dines out more often would find these meals more expensive due to the higher inflation, compared to others who rarely dine out.
Causes of Inflation
In general, the inflation rate of an economy can be caused by various factors which include the following:
Demand-pull inflation arises when demand exceeds the supply of goods and services in an economy. To put it simply, when supply is insufficient to meet consumer demand, prices will go up, leading to inflation.
A surge in money supply in an economy can also contribute to inflation. With more money in hand, consumers tend to spend more, causing price levels to rise as the supply of goods and services struggles to meet the increased demand. From an economic perspective, demand-pull inflationary pressure is commonly referred to as “too much money chasing too few goods”.
Cost-push inflation is a result of increased costs of production due to rising labour wages or raw material prices. This pressures manufacturers or service providers to pass on the higher costs to their customers by raising prices of goods and services.
For example, when oil prices rise, it will increase electricity and transportation costs, prompting suppliers to raise selling prices to accommodate higher production costs.
Inflationary pressures can also arise from the higher cost of imported goods. For example, a depreciation in the Ringgit will raise the cost of importing foreign goods. This exerts upward pressure on the general level of prices, causing inflation to build up. Likewise, when the Ringgit appreciates, the domestic inflation rate will ease as imports which are denominated in foreign currencies become cheaper and more affordable. As such, movements in the exchange rate may have an impact on domestic inflation rates.
In conclusion, investors who have a good understanding of the impact of inflation on their purchasing power and investments will do well to select investments that will keep ahead of the inflation rate over the long term. For investors who seek long-term capital growth, a well-diversified portfolio of equity funds can help to protect their wealth from the effects of inflation, as equities generally provide long-term returns that outpace the inflation rate.
This article is prepared solely for educational and awareness purposes and should not be construed as an offer or a solicitation of an offer to purchase or subscribe to products offered by Public Mutual. No representation or warranty is made by Public Mutual, nor is there acceptance of any responsibility or liability as to the accuracy, completeness or correctness of the information contained herein.
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