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Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.
~ Sam Ewing

We only have to go to a local grocery to know what inflation is all about - rising prices. The worry we have is that our income is not rising as fast and we don’t really know when it will get better.

I am going to put to you that inflation is here to stay and you cannot sit and wait long enough for it to go away. This article explains the cause of inflation and why you should care about it.

What causes inflation?

It’s actually very simple - when the money supply in an economy increase at a faster rate than the goods and services produced, prices go up and you have inflation.

We can turn to the M3, the broadest measure of money in an economy, and its rate of change to get an idea how fast money supply is growing. The table lists M3 rates for the stated month compared to that of a year ago.

   Australia   16.0%   Jun'07
   Canada      12.8%   Nov'07
   China (M2)  17.3%   Mar'07
   Eurozone    12.3%   Oct'07
   Russia (M2) 44.1%   Aug'07
   Singapore   23.6%   Jun'07
   UK          12.4%   Oct'07
   USA*        15.0%   Nov'07

* The United States Feds have stopped publishing its M3 since March 2006. The rate above is derived from widely quoted figure from ShadowStats.com.

How much inflation is there?

To do anything about inflation, you need to first know how much inflation is there.

For the man on the street, inflation is presented in the form of Consumer Price Index (CPI) - an index measuring the average price of consumer goods and services purchased by a household. I tried reading up on how my government calculates the CPI but the statistical models used were simply too overwhelming.

My instincts and day-to-day experiences tells me the official CPI is understated.

Instead, I use a simple, but fundamentally correct formula to derive an inflation number which I can live with

Inflation = M3 rate - GDP rate

So, in Singapore, the inflation that I’m dealing with is (23.62 - 7.7) = 15.92% (I’ll round it up to 16% for discussion purposes).

How does inflation hurt you

Inflation deals you a one-two punch in terms of your financial planning. First, you end up savings less because a bigger portion of your income goes to expenses. Second, your current savings gets eroded over time.

Here’s what a savings of $10,000 yielding 1.5% interest will buy me in terms of the same amount of goods in the first year:

Year  Principal   Buys in Yr 1
  1     $10,000     $10,000
  2     $10,150      $8,526 (10,000 x 101.5% x (1-16%))
  3     $10,302      $7,269
  ...
  5     $10,613      $5,284
  ...
 10     $11,434      $2,381

So, in 10 years, the $11,434 in the bank will only buy you $2,381 worth of goods and services in Year 1 dollars. In other words, the purchasing power of your savings are eroded through inflation.

I have another 24 years to my retirement age in Singapore. Using the same formula but more optimistic parameters (inflation 10%, savings interest 2%), I will still see my initial savings of $100,000 dwindle to barely $14,000 by the time I hit 62.

To see my savings devalue by as much as 86% is a big concern. In part 2 of this article, I will be sharing about what I’m doing to beat inflation.