Inflation

Inflation is the true enemy of building wealth and investors should put measures in place to protect against inflation’s corrosive downside.

“Inflation” can be defined as “the state of affairs when the value of money falls and the prices of goods and services increase, other things being equal”.

Interest rates move up and down from time to time – partly because of market forces but, especially in the case of short term rates, mainly because of action by the Reserve Bank of Australia. The reason given by the RBA for increasing rates is to slow down the economy, in the hope that making borrowing more expensive will reduce the demand for labour and other resources, from both home purchasers and businesses.

However, this rationale overlooks two things – that higher interest rates are themselves a direct inflationary factor and that such rates also enable the recipients of higher interest payments (including retired persons) to increase their spending. This latter is inflationary because it increases the demand for goods and services without correspondingly increasing their supply.

Inflation is very relevant to investors. Its effect can best be illustrated by an analogy. If the Federal Government were to go to all owners of five-room houses and compulsorily acquire one of their rooms without compensation, then there would probably be a revolution.

Again, if the Government were one night to confiscate 20 per cent of all deposits in savings institutions – or to impose an equivalent special one-off tax – then the political outcry would be unbearable.

But that is precisely what the Government does to savings during a period of inflation, except that it does it more surreptitiously, by keeping the number of dollars constant while reducing their unit value, rather than the other way around, and by doing this in small gradual stages rather than in one dramatic fell swoop.

Investment in securities denominated in dollars is thus a sure recipe for disaster in times of high inflation and really poses a much larger hazard than most people seem to realise.

The risk here is different in character from the other risks inherent in equity situations, but the chance of loss – as the reduction in asset values is a virtual certainty – is in a sense much greater.

Nor, despite a popular belief to the contrary, can investors avoid erosion of their savings by making deposits on an “at call” basis rather than for longer terms. Either way, after 365 days a year’s inflation will have been at work.

This situation affecting a unit of currency should be contrasted with the position of other units in common use. The length represented by one metre and the mass represented by one kilogram do not change each year.

The RBA uses monetary policy in an endeavour to keep inflation within a target range of between 2 and 3 per cent. This sounds reasonable enough over a short period, but such rates can be quite stgastating over a lifetime. To illustrate, in the 40 years to 31 December 2007 the Consumer Price Index (CPI) has increased from 15.8 to 160.1. This means that in that period the purchasing power of the Australian currency has fallen by over 90 per cent.

A hypothetical investor with a portfolio which yielded no income but the total value of which moved up exactly in line with the CPI would more or less preserve the purchasing power of his or her savings. However, such an investor would have had no reward for the sacrifice made by not spending the money or the risks which any investment entails. Ideally, therefore, investors need to outperform the CPI – after allowing for income tax – and to do so by a reasonable margin each year. Otherwise they are effectively going backwards.

Wage movements would provide another yardstick by which inflation could be measured. In a sense this standard would be more relevant to investors, as the moral case for maintaining the purchasing power of capital is at least as strong as that for maintaining the purchasing power of labour.

Over long periods wages have moved up to a greater extent than prices, partly because of the industrial muscle of trade unions and partly because productivity gains have been passed on to the workers rather than to the suppliers of capital and know-how which made such gains possible in the first place.

Investment in ordinary shares is often recommended as a means of preserving purchasing power (as well as a means of benefiting from Australia’s economic growth).

Unfortunately, there is no great correlation between the prices of goods and services and share values in the short term – as current investors are seeing every day. Nevertheless, in the long run the value of shares across the board (and of other equity investments, such as property) tends to move in the right direction, while the value of cash and fixed interest investments does not.