Investment Essentials: Inflation & Interest Rates

Over the last year, we have experienced a rise in interest rates and often heard the word ‘inflation’. It is important to understand the impact of inflation and the role that the interest rate plays in the economy.  This, in turn, impacts your portfolio, which is why it is important to make sure that you invest in asset classes that are able to outperform inflation.

What is inflation?

Inflation refers to a general increase in the prices of goods and services. In South Africa, inflation is measured by the Consumer Price Index (CPI), which refers to the average cost of a fixed ‘basket’ of goods and services typically used by the average South African. As at the end of September 2022, the South African inflation rate (CPI) was 7.5% (StatsSA). This means the prices of goods and services have risen on average by 7.5% per annum over the last 12 months to the end of September. For example, a basket of goods priced at R1 000 a year ago would now cost you R1 075.

So, inflation is reducing your buying power, as you need more money to buy the same product or service now, compared to a year ago.

What impacts inflation?

There are basically two types of inflation, (i.e. cost push inflation and demand pull inflation):

• Cost push inflation refers to the increase in production costs as a result of a rise in, for example, raw material prices and wages. Even if the demand for goods and services remains unchanged, the total supply of goods and services reduces as a result of higher input/production costs. Simply put – prices will rise when it becomes more expensive to deliver a product or service. For example, fuel prices rise in the case of crude and gas shortages. As a result, the entire process to turn raw materials into finished products becomes more expensive. Inevitably, the Russia-Ukraine war has had an enormous impact on the global supply chain, resulting in cost push inflation.
• Demand pull inflation refers to the general increase in the demand for goods and services. Where the supply of goods and services is limited but the demand for these increases, it usually means consumers are prepared to pay more to obtain the product or service – resulting in a rise in prices.

Although total demand may be determined by various factors, the latest increase in demand can be ascribed to the fact that money supply has been expanded by central banks – more money has been printed and social grants have been paid, with more cash in circulation in the economy. Furthermore, interest rates were at record lows just over a year ago. As a result, consumers have been more inclined to incur debt and spending more in the process.

Why do interest rates rise?

Interest rates are one of the monetary policy tools used by the South African Reserve Bank (SARB) to control inflation and bring it within its 3% – 6% target range.

The SARB’s monetary policy committee (MBC) lowers interest rates to stimulate the economy by encouraging spending, and hikes interest rates to cool down the economy by reducing spending.

Rising interest rates mean debt becomes more expensive, but at the same time interest-bearing instruments deliver higher investment returns.

You may want to pay off ‘expensive’ debt first, but don't forget that time in investment markets is also crucial to beat inflation. Will after-tax returns on interest-bearing investments be able to outperform inflation over time?

You are welcome to contact me to discuss your unique circumstances and find the appropriate solutions for your portfolio.