The Inflation Illusion

What is inflation? In Economics 101 (which I must confess to not have taken formally in school), inflation is the phenomenon of price increase in the general price of goods and services over a period of time. When this happens, it might that for the same amount of money, we will be able to buy less in future. Or in economics speak, one’s purchasing power decreases as a result of currency depreciation. In Singapore, we measure inflation using the Consumer Price Index (CPI), which is compiled by the Department of Statistics monthly. For more information on inflation with the local Singaporean context in mind, check out this brilliant Economics Explorer series put together by MAS.

Singapore’s inflation experience aside (which is far too short anyway), I thought the history of inflation on a global scale also gives a good understanding of this phenomenon. You can look up these sources to get more details: Investopedia or Wikipedia. I claim no expertise on this topic, but here is my quick laymen recollection of it anyway. In the past, the Romans devalued their silver coins by making coins with less silver content after melting earlier versions so that they could make more coins with the limited supply of silver. In modern times, with fiat currency like dollar notes that have no intrinsic value, all the US central bank have to do is to print more notes. Simplistically, they do this because the US borrows from other governments, particularly China, and one way to make sure that they can repay their debts is to print more money. With such an oversupply of money (and even more as part of “quantitative easing measures”), it is no wonder that costs will rise because the value of money decreases over time.

Now imagine the three scenarios below and how you feel about it.
Scenario A: Receiving a 2% pay raise when inflation is 4%.
Scenario B: No change in pay when inflation is 2%.
Scenario C: 2% pay cut in a zero inflation environment.

Most people will feel happier in scenario A because of the pay raise but in real terms, all three scenarios result in the same outcomes in your financial position – being worse off by 2% after inflation. And that is the inflation illusion that we have been fed in recent times. So what kind of inflation environment have we been in the past few years? That will allow us to better appreciate the context within which we are receiving any pay raises and whether our financial position is truly improving over the years.

Singapore’s average inflation rate is about 3% over the years

You can check out Singapore’s inflation rates for the past 80 years and look at a narrower time period here: Singapore Inflation Rate 1961-2020. Of more interest to us is perhaps the last couple of years, where the average yearly inflation has been pretty stable at about 0.5%. It is projected to be negative in 2020 because of the COVID-19 situation. So that means anybody who has a pay raise in the past couple of years will have quite likely improved on their spending power. And anybody who was fortunate enough to not suffer a pay cut or lost their job (quite possibly nobody) will likely be in a better position than they were in the previous year.

Inflation is also a good indicator of the success of your investment returns. Leaving money in a piggy bank means its value gets eroded over time, less so if it is a fixed deposit or savings in a bank. So when it comes to investing, you want to make sure that your overall portfolio can provided returns that allow you to swim against the tide of inflation that we constantly face. It is like swimming against the current – stop and you will constantly get pushed further back.