How inflation can affect your savings

Why it’s important to understand how inflation can erode your buying power

When you’re investing for retirement, you want to make sure the return on your assets exceeds inflation, so that your purchasing power doesn’t erode over time. Here’s why.

Recent trends in inflation

Every quarter the Australian Bureau of Statistics releases a measure of inflation called the Consumer Price Index, or CPI. The CPI reflects the change in price of a basket of goods and services, weighted in such a way as to be representative of the consumption patterns of the average consumer.

For the year to June, this figure was 1.9%. Of course not everything goes up at the same rate, and some categories such as healthcare, and alcohol and tobacco, were up by more than this, while the cost of clothing and footwear, and communications, actually fell.

How does inflation influence interest rates?

The Reserve Bank of Australia has an objective to maintain stability in prices, which they interpret as keeping inflation within a range of 2 to 3% over time. The way they do this is by setting the official cash rate, which influences the cost of borrowing in the economy.

Generally speaking, when the inflation rate is too high, they raise the cash rate, and when it’s too low they reduce the cash rate.

Since the Reserve Bank adopted this approach in the early 90s, it’s been quite successful, with inflation averaging around 2.5% a year for the last 20 years. More recently though, inflation has been a bit lower, just 1.5% on average over the last 3 years.

It’s not the same for everyone

It’s worth keeping in mind that the CPI measure is an average. Every household will have their own individual consumption pattern, which itself may change over time.

Actually, after taking into account the differences in spending patterns, the data shows that more recently, inflation for people in retirement has tended to be a bit higher than for those still working.

It’s difficult to know for sure whether this divergence will continue, but it seems likely that healthcare and electricity costs will continue to rise, at least in the near term. So it could well be the case that the inflation rate for retirees stays higher for a bit longer.

What does this mean for your investments?

In order to meet your goals you’ll need your investments to grow faster than inflation. When the inflation rate is low, the returns you need to earn are also a bit lower, so when the Reserve Bank reduces the cash rate it’s not necessarily a problem.

But you do need to think about your own individual circumstances, because the headline rate might not tell the whole story.

Your financial planner can help you understand the impact that inflation can have on your ability to fund your retirement, and how to structure the right investment portfolio for you.