Inflation is one of the most talked-about economic terms – but what is inflation? What does it mean for the economy and especially, for you?

Inflation is a sustained increase in the general price level, representing a decrease in the purchasing power of money. When the price of goods and services like housing, clothing, food, transportation and fuel are increasing steadily, the economy is undergoing inflation.

What inflation usually means, in practical terms, is that the average consumer will have to spend more to get the same things. This is an uncomfortable reality, although some economists believe that a certain level of inflation – around 2% in advanced countries and about 5% in developing countries – is a sign of a healthy economy.

But when inflation rises too high, consumers can afford fewer goods and services and the economy suffers. When inflation gets out of control, the value of a currency is completely eroded. If inflation should skyrocket to 1,000% a year, as it did in Zimbabwe in 2003, the results can be catastrophic. By the end of 12 months, goods and services would cost 10 times as much as they did at the start of the year.

This situation is called hyperinflation, and it can lead to massive social upheavals. As the value of a currency plummets, people rush to buy items they need, effectively offloading their worthless currency, which leads to empty shelves in stores.

The opposite of inflation is deflation, which is when prices decrease due to supply exceeding demand in an economic downturn. Prices dropping too far can signal a recession.

What causes inflation?

High inflation can be the result of a booming economy, when people have a lot of surplus cash or are accessing a lot of credit and want to spend. If consumers are buying goods and services eagerly enough, businesses may raise prices because supply is under pressure.

In some instances, inflation is affected by developments only partly related to economics. When wars affect oil production and distribution, fuel gets more expensive – with a knock-on effect on the cost of everything else. If pandemics or protests disrupt supply chains and keep goods in short supply, it also pushes up prices.

How is inflation measured?

Governments calculate official consumer inflation statistics through tracking the price of items that consumers commonly buy. These include clothing, footwear, transport and energy costs. This is referred to as the consumer price index (CPI).

Producer price inflation is another measure of inflation. It tracks the prices that manufacturers pay for the raw materials needed to make their goods.

Why increase interest rates when inflation rises?

Inflation and interest rates are closely tied. Central banks in most countries try to control inflation by regulating the pace of economic activity. If they raise interest rates and keep borrowing costs high, it discourages spending, relieving the pressure on supply, which ultimately brings prices down.

The opposite is also true: if inflation is low and an economy is growing too slowly, central banks might cut interest rates to stimulate more borrowing and more spending. The South African Reserve Bank’s (SARB’s) mandate is to keep inflation in South Africa within a target range of 3% to 6%.

What does inflation mean for you?

Inflation means a gradual decline in the buying power of your money. In a few months’ time, R100 won’t put as many items in a supermarket basket as it does today. If your income doesn’t increase annually to keep pace with inflation, you’ll be able to afford fewer goods and services in the future and your standard of living could be affected.

As already noted, inflation can trigger higher interest rates that increase the cost of borrowing. This increases financial pressure on households and businesses with debt. By reducing the value of cash faster, high inflation rates can also discourage saving – it's important to choose saving and investment accounts with returns that compensate for inflation, and still allow your money to grow in real terms.

Remember that most investments yield better returns if you stay invested for a long time, whatever the fluctuations in the inflation rate. Overall, your best defence against inflation is a combination of low-, moderate- and higher-risk investments in your portfolio, so that the average interest rate of your combined holdings remains above the inflation rate.

Speak to your investment advisor about a strategy to keep your investment goals on track even in an inflationary environment.

Nedbank offers a range of investments over the short, medium and long term to help you fight the effects of inflation.