Understanding inflation: when your money is worth less

Inflation is regularly in the news, the source of much angst, and not just an important topic for economists but for everyone in general. But what does it really mean? How does inflation affect your purchasing power and savings? Is it necessarily a bad thing?

Inflation refers to the generalised and sustained rise in prices over a given period of time – in other words, a rise in the general level of prices. Inflation of 2% means that a certain basket of goods and services that cost you EUR 100 a year ago will cost you EUR 102 today.

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, or 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 in particular;
  • too much money in circulation in comparison to the goods and services available in the market.

Calculated by Statec

Statec, the Luxembourg statistical office, regularly calculates the average rise in the consumer price index to determine inflation. This index is calculated as a result of a representative statistical survey based on the prices of hundreds of goods and services that make up a large part of our average expenditure (known as the basket of goods). Food, energy, transport and housing are all included in this basket. The composition of this index is regularly adjusted. In 2021, inflation in Luxembourg was 2.5%, according to Statec.

Inflation implies that the value of money, or 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 falls. A system has been set up in Luxembourg to limit this negative impact. This consists of periodically adjusting wages and salaries in line with changes in the price of the basket of household goods.

If inflation rises and you have a fixed interest rate, this is to your advantage

This system is referred to as automatic wage indexation, which was established decades ago to offset the loss of employees’ purchasing power. Under this system, wages, pensions, annuities 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 the purchasing power, with a slight lag.

Impact of inflation on savings

If inflation rises and interest rates remain low, 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 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 run the risk of losing purchasing power and therefore being worse off financially. So why not look at other more profitable solutions? Have a chat with your banker, who will help you put together a financial plan to suit your situation.

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 the major central banks’ aim is to keep 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 indicates weak demand. If it is too high, it undermines any analysis of the potential profitability of investment projects. It’s all a question of balance.

Who are the winners and losers when inflation rises?

If rising inflation means that purchasing power decreases, is an increase in inflation necessarily negative for everyone? No, actually. Its impact will 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.

If you are a student and you have taken out a student loan or a 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.

There are certain things you should be aware of when it comes to inflation in order not to lose your purchasing power.

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 a 10 year period, the purchasing power of your savings will have declined by around 18%.

If you plan to borrow money to finance a project, any rise in inflation is an advantage provided that you go for a fixed-rate loan. 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.

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 potential enhanced earnings for companies, and the hope of more generous dividends and an upwards revaluation of the shares for investors.

Is inflation necessarily a bad thing?

If you are retired with no other income than your pension, the simple truth is that a rise in prices across the board, 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.

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. There are certain things you should be aware of when it comes to inflation in order not to lose your purchasing power.