Why inflation is a big deal

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There is a strong feeling among shoppers in Nairobi that the Sh1,000 note is worth Sh100 some ten years ago.

This sounds like just one of those crazy whining about the high cost of living. But there is some truth in it. Yes, the Sh1,000 in 2012 is worth Sh1,679 today!

If you are an investor, the rule of the thumb should be: Money today is worth more than money in the future. Banks, which charge huge interest rates, know better.

How many times have you bought items from the supermarket only to find that the price has gone up a month later?

Even worse is if you try to buy the same items a decade later. It is not just this set of items that will retail at higher prices, almost everything will be expensive.  As a result, the items that a Sh1,000 buys today shrinks considerably.   What really happens? Inflation happens.

More money less products

Inflation is the increase in the average price level of goods and services in the country over a given period of time, usually a year. It is the barometer for the changes in the cost of living.

Of course, inflation does not mean that all prices of all goods and services rise during a given period of time, but let us assume that you have Sh1 million that you want to buy a piece of land. Instead of buying the land right away, you decide to put money in a fixed deposit account for a year. The money earns an annual interest of three per cent.

Months later, you decide you are ready for the purchase of the land. But alas, the land is now going at Sh1.2 million, but by then your money has only earned an additional Sh30,000.

In essence, your purchasing power has declined by Sh170,000.  

Almost everyone- workers, pensioners, investors, government- need to shield themselves against inflation.

If you want to save or invest you need to take your money where the returns equal inflation (for saving) or are higher than the inflation rate for investments.

Invest with inflation in mind

Sara Wanga, the head of research at AIB Capital, an investment bank, says people should have inflation in mind when they are saving or investing.  

Even more critical is the need to differentiate between nominal interest- which is the additional Sh30,000 that you got from the bank when you saved your Sh1m in a year; and the real income, which is the difference between inflation rate and the nominal rate. In this case, your real interest has actually declined by Sh170,000.

When prices rise, people worry whether the rise in their income will keep pace with inflation. And the more quickly prices rise, the more people suffer from the stresses of inflation and its uncertainties.

At the end of every month, the Kenya National Bureau of Statistics (KNBS) releases what is known as Consumer Price Indices (CPI) and inflation. CPI is kind of a cost of living index that measures the changes in the average prices of consumer goods and services. It is CPI that is used to measure inflation.

Ms Wanga notes that normally analysts take into account various economic indicators that drive up inflation-majorly food and fuel in projecting inflation.

“For example, if oil prices are rising, that will have an impact on inflation,” says Wanga, noting that reading will also help have a pulse of inflation.

Levels of inflation

Inflation generally occurs in two ways- when there is increased demand and when there is a reduced supply of goods and services. Inflation as a result of increased demand is known as demand-pull inflation as there is more money in the economy chasing fewer products.

Then there is inflation caused by an increase in the cost of products, for example, when the rains are not good leading to a scarcity in fresh produce. This is known as cost-push inflation.  

Ken Gichinga, an economist in Mentoria Economics, a consultancy, gives the example of the current inflation which is at around five per cent.

“To shield yourself from that inflation, you want to invest in anything that gives you a return of above five per cent,” advices Gichinga.

Putting a Sh100,000 in the 91-day T-bill, for example, will earn you an additional Sh7,000. Your nominal return, or what you get on paper, is Sh7,000. But if you adjust for inflation, you will have a real return of Sh2,000 (or real return).

Some investors prefer to put their savings in dollar accounts which have relatively lower returns than the Kenya shilling accounts.

“That is because the inflation there is relatively low, non-existent currently,” says Wanga, noting that their returns are still higher than inflation.

“Shilling usually depreciates against the dollar so most people prefer investing in the dollar. So, return is lower but your real return is higher or equal to seven per cent you are being in Kenya Shilling.”

CBK is the one responsible for keeping the prices stable- they don’t rise or decline too fast. They use various tools- known as monetary tools- to keep the prices stable, mopping up excess money when there is too much supply or pumping cash into the economy when the supply is low.

Surprisingly, a lot of people, even those with understanding, still put their money in areas with negative real returns.

Lack of understanding

Lack of understanding, says Gichinga, is one of the reasons people put money in asset classes whose returns are eroded by inflation. Oftentimes, people can put money in, for example T-Bonds with a lower real interest rate, but they are looking for the safety of their funds.

The Government will always pay its debts. “In Finance, there is something they call the risk-return model. “The higher the risk, the higher the return, the lower the risk, the lower the returns,” explains Gichinga.

There is also a feeling that sometimes inflation numbers are a bit exaggerated. Whereas calculation of inflation is based on an assumption that people will always consume the same products in a basket of goods next year, that is not always the case.

“But people are always looking for cheaper substitutes,” says Gichinga, noting that it is very rare to find someone consuming next year the same things they consumed this year.

“Next year, the food patterns will have changed. Maybe you will have moved to a different neighborhood. Maybe you are using Uber more than bus fare,” says Gichinga.

Even worse is that KNBS takes longer to update the basket.  

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