3 Important Things You Need to Know About Inflation So You Can Budget for It

The Simple Sum

07 Mar 2024

Inflation is an economic reality that affects the prices we pay for goods and services daily. It has a significant impact on our finances as it erodes our purchasing power. As prices increase, over time, we would be able to buy fewer items with the same amount of money.
While it is common knowledge that inflation leads to higher prices, other subtleties of how inflation can affect our finances often go unnoticed. Understanding these aspects of inflation will help you create more realistic budgets.
Here are three crucial aspects of inflation that may not be commonly discussed but are essential for effective financial planning.

1. Inflation has a compounding effect

One key aspect of inflation that often escapes our attention is its compounding nature. If inflation leads to higher prices in a given year, those elevated prices become the starting point for the next year's inflation. This compounding effect means that prices will consistently increase (unless the economy experiences a recession, leading to deflation). Now suppose that the average rate of inflation annually is 3%. If you normally spend $350 a month on groceries, your grocery spending would increase to $360.50 per month in the first year. In the second year, inflation is calculated not from the original spending ($350) but from the elevated spending ($360.50) after the 3% increase. So, in the second year, your grocery spending would increase from $360.50 to $371.30. Over several years, this compounding factor could lead to a substantial increase in the overall cost of living. If you don’t take this compounding effect into account, you could face financial strain.

2. Inflation affects everyone differently

While inflation is often discussed as a broad economic phenomenon, its repercussions are deeply personal and intricately linked to individual spending habits. Inflation itself is measured using the Consumer Price Index which evaluates the average change in prices across a predefined basket of goods and services consumed by households. However, this basket might not reflect the unique mix of products and services that you use as a consumer, so it won’t reflect your spending patterns accurately. For instance, if a significant portion of your budget is allocated to healthcare, you should look at the average rate of medical inflation. This rate can differ from the rate of general inflation. To illustrate this point, the annual inflation rate in Singapore last year was 4.8%, however, food costs were estimated to have increased by 5.8%. That’s a 1% difference. So, planning for a 4.8% increase in your budget wouldn’t be sufficient to cover all your food needs. To tailor your budget effectively, scrutinise your spending patterns and find areas that are more susceptible to inflation. In essence, personalising your approach to inflation ensures that you are prepared for all the price increases that come your way.

3. High inflation prompts higher interest rates

High inflation is likely to prompt central banks to raise interest rates. As a result, borrowers may face higher interest payments on their loans. For individuals with variable-rate loans or those considering taking out new loans, it's crucial to budget for potential increases in interest rates.

Conclusion

Inflation is a multifaceted economic force, and understanding its intricacies is necessary for effective financial planning. By acknowledging the compounding nature of inflation, personalising its impact on your budget, and preparing for potential interest rate hikes, you can steer through the challenges posed by rising prices to safeguard your financial well-being.