My finances, my projects, my life
August 8, 2022

Understanding inflation

  Compiled by myLIFE team me&myFAMILY December 3, 2021 31

Inflation is regularly headline news, the source of much angst and a concept that is very closely monitored by many economists. But what does it really mean? How will it affect your purchasing power and savings? Is it necessarily bad news? The myLIFE team is here to guide you!

What is inflation?

Inflation refers to the generalised and sustained rise in the price of a basket of goods and services over a given period of time. Annual inflation of 2% means that this basket of goods of services that cost you EUR 100 a year ago will cost you EUR 102 today.

Inflation refers to the generalised and sustained rise in the price of a basket of goods and services over a given period of time.

Many factors can influence inflation, and economists regularly debate the causes and consequences of these factors, in particular:

    • an increase in the cost of raw materials or wage costs;
    • demand for goods or services rising more quickly than supply, or conversely, declining supply while demand remains unchanged;
    • a fall in the value of the euro versus other currencies, which results in a rise in the price of imports;
    • too much money in circulation in comparison to the goods and services available in the market.

Statec regularly calculates the average rise in the consumer price index to determine inflation. This index is the result of a statistical exercise and is calculated on the basis of the prices of thousands of representative goods and services covering a large part of our average expenditure. Food, energy, transport and housing are all included. The composition of this index changes regularly over time. In 2021, the inflation rate in Luxembourg was 2.5%, which was slightly above the European average.

Is inflation an issue for my purchasing power?

Inflation expresses the fact that the value of money, or more specifically, the value of a euro, is variable, and as purchasing power is determined by the value of money, it too is variable. As inflation rises, purchasing power diminishes. A system has been set up in Luxembourg to limit this negative impact. This consists of studying the price of a basket of household goods and periodically adjusting wages in line with these changes. This is referred to as automatic wage indexation which was established in order to offset the loss of purchasing power of employees. Under this system, wages, pensions and other benefits are increased by 2.5% if the average cost of the basket during the previous six months reaches or exceeds a pre-defined threshold. This makes up for lost purchasing power with a slight lag.

However, it would be wrong to think that inflation is necessarily a bad thing and to be avoided at all costs. It is no coincidence that major central banks follow monetary policies aimed at holding inflation at a stable, moderate level, ideally at around or just below 2%.

Moderate and predictable inflation encourages economic participants to invest in their production capacity and to create jobs, as it reduces the uncertainty surrounding the future returns generated by these investments. If inflation is too low or negative, it acts as a black hole and demand is assumed to be lacklustre. If it is too high, it undermines any analysis of the potential profitability of investment projects. It’s all a question of balance.

What is true for companies also holds good for individuals, but for slightly different reasons. If savers are prepared to forego immediate expenditure in order to grow their capital, they expect the return on their savings to at least offset the rise in prices. Otherwise their future purchasing power will be lower than their current purchasing power and saving makes no real sense. In this situation, other investments should be prioritised.

Save or invest, what is the best approach?

Like many other households, you may well prefer to keep your nest egg safely locked up in a savings account, rather than investing it. If inflation rises and interest rates remain low, you should be aware that the purchasing power of your savings may also be eroded. If the interest rates offered on your savings accounts are lower than the inflation rate, the value of your savings will fall. We all know intuitively that EUR 500 today will not buy as much as EUR 500 bought 15 years ago. Even if the amount on your account remains the same or rises slightly, you therefore run the risk of falling purchasing power and wealth. Why not look at other more profitable solutions for investing your excess liquidity? The best way to do this is to have a chat with your banker, who will help you put together a financial plan to suit your situation. In addition, irrespective of the inflation issue, it’s very helpful to consider the appropriate weighting between savings and investment, and to get a good grip on the investment pyramid principle.

In general terms, it’s fair to say that inflation tends to penalise savers and consumers, and favour borrowers and investors.

Who are the winners and losers when inflation rises?

Although rising inflation undermines purchasing power, it isn’t necessarily a bad thing for everyone. Its impact may vary depending on your situation. In general terms, it’s fair to say that inflation tends to penalise savers and consumers, and favour borrowers (at a fixed rate) and investors. Let’s have a look at a few examples to illustrate the potential impact of inflation.

Example 1:
If you are a student and have taken out a student loan or government-backed loan to finance your education, the good news is that either your interest rate is fixed, or any change in rate is covered by the government. Your total debt will remain the same, whilst its real value will decline in relation to the cost of living.

Example 2:
If you have managed to put some money aside on a savings account to offset any loss of income on retirement, the bad news is that your purchasing power will decline. If inflation is 2% above the return on your savings over 10 years, the purchasing power of your savings will have declined by around 18%!

Example 3:
If you plan to borrow money to finance a project, if properly planned, any rise in inflation is an advantage, provided that you go for a fixed rate loan. Indeed, any fixed rate offered will, in principle, be higher than the variable rate at the time, which means that the interest you pay will be higher at the start of the loan, but will not be affected by rising inflation. In contrast, choosing a variable rate will bring short-term savings, but could prove expensive at the end of the loan period if rates rise significantly due to inflation before the loan matures.

Example 4:
If your aim is to diversify your assets, a controlled rise in inflation should be favourable for stock markets as it stimulates the economy. This scenario means the prospect of enhanced earnings for companies, and the hope of more generous dividends and an upwards revaluation of the shares for investors.

Example 5:
If you are a pensioner with no other income than your pension, the simple truth is that an across the board rise in prices, particularly for food and energy, will mean a loss of purchasing power for you. Thankfully, automatic wage indexation in Luxembourg will offset this fall when activated. However, the ideal scenario is to plan in advance for your retirement and adapt to the reduction in income when the time comes.

Inflation is essential to the proper functioning of our capitalist economies. However, to avoid any erosion of purchasing power, it must be controlled and properly planned for. Its impact will vary greatly, depending on your individual situation. Talk to your banker, who can help you make the right decisions.