How does inflation arise?
The term "inflation" comes from Latin and can - directly translated - be equated with an "inflation". What inflation is is quickly explained: it stands for an increase in the price of products and services on the market. Currently, you can see this in particular in the increased oil prices.
Inflation is caused by central banks increasing the money supply. To stimulate the economy, they may decide to support the market with additional liquidity. This results in the following scenarios:
- A higher money supply can be distributed over more products and services. Companies increase their capacities and turn over more.
- The higher money supply meets constant product quantities. In order to meet demand, prices consequently rise.
A rising price level leads to higher salary demands for a large number of people in order to maintain their own purchasing power. This results in a higher salary level and higher costs for companies. They try to pass these on to their customers through higher prices. Inflation leads to a wide range of chain reactions. Currently, the increased energy prices in the context of the Ukraine crisis are leading to higher costs for companies.
Central banks have the task of stabilising inflation at a "tolerable" level. Currently, the upper limit is two percent per year. When the media speak of an inflation rate, it often describes consumer prices compared to the previous year.
Effects of inflation?
Depending on the type of inflation, the effects are different. In the following, we focus on the impact of inflation on investors and savers.
Let us assume that the general price level has risen by five percent in the past year. In this case, 1,000 euros are worth less in "real" terms because they no longer have the same purchasing power. Now it is important to note that inflation does not necessarily apply to every product and service. We are never equally affected by inflation. People who do not currently drive a car will be less concerned about the rise in oil prices than people who drive to work every day.
On average, however, inflation lowers the average purchasing power of our money due to the above-mentioned chain reaction - every year anew. With an average inflation rate of 1.5 percent, a savings balance of 1,000 euros is "only" worth 860 euros in 10 years. Especially in times of low interest rates on bank deposits, inflation has a significant impact on our financial assets.
However, savers can counteract the declining purchasing power by investing their money profitably on the capital markets. Over the past 50 years, a global investment in the stock market (MSCI World) has yielded an average annual return of almost seven percent. This was enough to beat inflation.
Important note: The risk with savings deposits is the sustained reduction in purchasing power. The capital market is an alternative to the interest-free savings deposit - but is associated with high risks of loss up to and including total default. Markets can collapse at any time due to uncontrollable events. You should be aware of this risk at all times.
Causes of inflation
At the end of the day, the causes of inflation lie largely with the central banks, which control the money supply in the market with their monetary policy. Their goal is to establish price stability, which goes hand in hand with inflation of 1.5 and 2 per cent.
The following instruments are available to the central banks for this purpose:
- They can lower key interest rates and thus encourage consumption in the market
- Liquidity can also be increased through asset purchases (e.g. bond purchases). This instrument is used especially in times of financial crises
- By charging negative interest rates on commercial banks' deposits with the ECB, central banks generate the incentive to pass on these funds to customers by way of credit and thus promote consumption and investment
Central banks take on a supporting role and are responsible for maintaining price stability. For the population, this means better predictability.
Special case "stagflation
In stagflation, weakening economic growth meets high inflation (stagnation & inflation). We can currently observe this special case in Germany. The consumer price index is rising, while economists expect a weak economic year.
Inflation usually only occurs in phases of particularly high economic growth. Prices rise because more and more people have a job and thus stimulate demand. Why does stagflation pose a threat? When prices rise, employees' salary expectations also rise. However, if companies want to make savings, this situation leads to large waves of layoffs in the worst-case scenario. Breaking out of this cycle can be difficult.
Conclusion
Inflation is in principle a good sign, as it can be directly linked to economic growth. However, it can also become a danger for people who allocate large fortunes to their savings accounts. If the purchasing power of assets falls, people can afford less in the long term.
Due to the high risk of loss with real estate, shares and other asset classes, experts repeatedly recommend broad diversification in order to spread the risk of asset development over several pillars. Returns are always associated with risk - but an investment in a savings account is also associated with the risk of losing purchasing power, and you should be aware of this.
