Inflation: Friend or foe?

IS INFLATION – the rise in the average price of goods and services in the economy -  a good or a bad thing? 

As a proper economist, I will argue “it depends”. Which is why former US president Harry Truman asked for a one-armed economist: because he found all his advisors kept saying, “it depends, on one hand…, but on the other hand…”.

Inflation is the rise in prices. Not of just some items, but of the general cost of living. 

The government tracks inflation by making a hypothetical “basket” of products and services which they believe the average person consumes. 

The basket includes your energy consumption, food and drinks, transportation, communication, entertainment etc. 

The government then tracks the changes to the prices of all the items in the basket over many years. 

The government also periodically makes adjustments to the content of the basket to reflect changes in society.

For example, it will now include the cost of smartphones and internet plans. 

There is no reason your expenses will exactly fit the average basket, which is why the inflation you are experiencing might be higher or lower than the “official” inflation number.

A price hike of a single product cannot be proof of inflation. In fact, many products are getting cheaper. 

To name a few, think about air travel, motorcycles and computer memory and processing power which have dropped significantly in price over the past decades. 

Your iPhone is more powerful than the computers in the space shuttle that brought the first man to the moon, and although still expensive, infinitely cheaper than NASA’s budget.

The opposite of inflation is deflation. Deflation means that your money is increasing in value as the general cost of living is getting cheaper. 

Some European countries are on the brink of deflation and Japan has suffered from it for decades.

Although deflation sounds awesome (stuff getting cheaper, all the time!) it actually hurts the economy as people will endlessly delay their consumption and will wait until things get even cheaper.
 
The delayed consumption slows down the growth of the economy as it goes into a downward spiral.

So is inflation good or bad for you? As I mentioned: it depends. If your net wealth (all your possessions minus all your debts) is positive, it will hurt you. 

Your money is decreasing in value and your wealth pays for less in the future. 

However, if your debts are larger, inflation will actually help you as you pay off your debt in the future with money that is less valuable, while you were able to spend the money you received as loans in the present, while it is still more valuable.

An extreme example will illustrate this point. 

Let’s say you take a RM40,000 personal loan at 8% interest and buy a small car. 

Then, a disaster strikes and Malaysia is suddenly experiencing 100% inflation for a single year. 

This could be a political event in the US or China or Malaysia or even a natural disaster. 

You will be able to buy much less (exactly half) with your money after the inflation hike. 

Therefore, you and everyone else will ask for a salary increase of 100%, just to make sure you can buy exactly the same stuff you could buy before the inflation hike. But your loan won’t double! 

The price of the new car will be RM80,000 and you are actually lucky that you bought it for “only” RM 40,000. 

Your loan won’t double and with your doubled salary it will be much easier to pay off the RM40,000 loan. 

Of course the opposite is true if you had saved RM40,000, with which you can now only buy half of the stuff you used to.

High inflation typically helps the younger generation, who have a lower net worth and student debt, but it hurts the older generation as they will have saved their entire life and would see the value of their savings diminish. So, I would argue inflation is your “frenemy”.

Of course, you have to compare the inflation rate with the interest rate you are paying or receiving. 

Both typically move in the same direction. If a high inflation is predicted, the banks will protect themselves by charging and giving higher interest rates. 

However, if the increased inflation comes as a shock, your debts will be quickly reduced. 

Mark Reijman is co-founder and managing director of https://www.comparehero.my/ dedicated to increasing financial literacy and to help you save time and money by comparing all credit cards, personal loans and broadband plans in Malaysia.