Inflation: the Unseen Force

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Inflation, a term prominent in financial news, especially following its recent global resurgence, fundamentally impacts our economic lives. As of today, while the peak of post-pandemic inflation has passed in many regions, it remains a key concern for policymakers and households. It's the silent erosion of purchasing power – the reason the same amount of money buys less over time. Understanding inflation – its definition, compounding effect, why major central banks target specific rates, and how to protect your finances – is crucial for long-term financial security.

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Defining Inflation: More Than Just Rising Prices

Inflation is the rate at which the general level of prices for goods and services rises, causing the purchasing power of currency to fall. It's not about a single price surge but a broad increase across items like groceries, fuel, and housing.

Economists measure inflation using price indexes. For example, in the Eurozone, the Harmonised Index of Consumer Prices (HICP) is key. An HICP increase signifies a rising cost of living, meaning each Euro buys less.

However, inflation should not be anchored to these indexes, as they are often created ex-ante by economists and may become obsolete over time. For instance, over from 2000 to 2022 looking at HICP (see below), one could have inferred that prices have been oscillating around 0.

However, this is just the result of some specific goods and services becoming very expensive, and others getting cheaper and cheaper. Hence, when looking at data (especially at indexes), it is very important to deep dive to understand what we are looking at.

Inflation can affect different things, and not all of them may have the same impact on the day-to-day habits of households. For example, inflation of commodities / consumer staples (which are needs of every family), may be more impactful than inflation on consumer discretionary and luxury goods (which are easy to surrender in hard times). Finally, inflation can affect assets as well and not just goods and services. In this case, whilst this may not have a direct impact on day-to-day consumers’ choices (aside from big decisions, such as buying a property) they may have an impact on inequality. In fact, asset-rich people may become richer, whilst cash-rich (or non-rich) people will not –actually, their cash may go down in value if there is also inflation related to goods and services–.

Inflation can stem from:

• Demand-pull inflation: Too much money chasing too few goods.

• Cost-push inflation: Rising production costs (e.g., wages, raw materials) passed on to consumers.

• Built-in inflation: A wage-price spiral.

While high, unpredictable inflation is damaging, moderate, stable inflation often accompanies a healthy economy.

The Compounding Power of Inflation: A Slow Burn on Your Savings

Inflation's impact, subtle short-term, becomes significant over time due to compounding. Price increases apply to already inflated prices, steadily eroding the real value of savings. 

The following table illustrates how the future cost of an item initially valued at €100 escalates under different sustained annual inflation rates – the central bank target of 2%, as well as hypothetical scenarios of 3% and 4% – demonstrating the varied erosion of purchasing power.

As the table clearly shows, the higher the inflation rate, the more dramatically the cost of goods increases over time. At the central bank target of 2%, an item costing €100 today would cost nearly €122 in 10 years and over €181 in 30 years. However, if inflation were to average 3%, that same item would cost over €134 in 10 years and over €242 in 30 years. At a 4% average inflation rate, the cost skyrockets to €148 in 10 years and a staggering €324 in 30 years. This highlights why managing inflation is crucial and why even seemingly small differences in inflation rates can have a large impact on your purchasing power over the long term. This means €100 saved today, if not growing at a rate that outpaces inflation, will buy significantly less in the future.

Why Do Central Banks Target 2% Inflation?

Major central banks worldwide, including the European Central Bank (ECB), the U.S. Federal Reserve (Fed), and the Bank of Japan (BoJ), generally target an inflation rate of around 2%. Why not aim for zero?

The 2% target helps:

• Prevent deflation, where falling prices harm investment and growth.

• Keep interest rates above zero, so central banks can cut them during downturns.

• Anchor expectations, so people and businesses can plan confidently.

• Account for measurement quirks, price indexes may slightly overestimate actual inflation, so a target above zero can account for such statistical nuances.

• Ease wage adjustments, since moderate inflation helps real wages shift without painful nominal cuts.

• In short, controlled inflation helps balance growth, employment, and price stability.

Protecting Yourself: Make Inflation Work for You, Not Against You

Now that we know that inflation is a built-in feature of the system, how do we protect ourselves? Well, the most obvious thing to do is to align our interest with the central banks. Let’s have a look at the following examples:

Ride the inflation: Visa — $V ( ▼ 5.0% )  and Mastercard — $MA ( ▼ 4.62% )  operate vast payment networks, earning revenue mainly through transaction fees. As prices rise due to inflation, their percentage-based fees generate higher dollar revenues without needing more transactions. For example, a 2% swipe fee on a €100 purchase becomes €2, but if inflation pushes the price to €110, that same percentage now yields €2.20 — a built-in growth lever. These companies also benefit from global scale and consumer spending habits that persist even in inflationary times. By owning Visa or Mastercard shares, investors can potentially capture part of the inflation-driven uplift embedded in the financial system.

Taking fixed-rate debt, pay back with cheaper money: Fixed-rate loans (like mortgages) lock in your borrowing cost in today’s money, but inflation erodes the real value of future repayments. Suppose you borrow €100,000 today at 3% fixed interest. Over 20 or 30 years, inflation reduces the purchasing power of each euro, effectively letting you repay the loan with “cheaper” future euros. Meanwhile, your income or asset values may rise with inflation, further lightening the burden. This strategy works best when inflation outpaces the loan rate — but caution is key: avoid over-leveraging and ensure you can cover payments even if economic conditions shift.

Now that you see how to address the problem, here’s a set of general guidelines:

1. Invest in Growth Assets: Historically, equities (stocks) have offered returns that can outpace inflation over the long term.

2. Consider Real Assets: Real estate (direct ownership or REITs) and certain commodities like gold can act as inflation hedges, though commodities are volatile.

3. Inflation-Indexed Bonds: Securities like Treasury Inflation-Protected Securities (TIPS) in the U.S. or inflation-linked bonds in the Eurozone adjust their value with inflation.

4. Manage Cash: While an emergency fund is essential, excessive cash loses real value.

5. Debt Management: Existing fixed-rate debt becomes relatively less burdensome with inflation. Be cautious with new variable-rate debt.

6. Enhance Earning Power: Invest in yourself, increasing your income can help maintain purchasing power.

7. Budget Review: Monitor spending and adapt to rising prices.

Conclusion

Inflation is an undeniable economic reality, a constant pressure on your financial future. The numbers are clear: the €100 in your pocket today will not hold the same power tomorrow, potentially needing over €181 to match its value in 30 years even at a modest 2% inflation, and far more if rates climb. Don’t let inflation quietly erode your hard-earned savings. Take action: invest wisely, manage debt smartly, and make your money work for you, not against you.