The reason for increasing interest rates again last week is to try and bring inflation under control. Inflation is generally regarded as an inevitable threat to one's material wellbeing. And while it is indeed an integral part of modern financial life, a better understanding of this "bogeyman" can help to guard against its damaging effects.
Broadly speaking, inflation is a rise in prices. Usually it means a rise in consumer prices, but it can also refer to wages, assets and other economic concepts. When inflation rises, money has less buying power because things cost more. That is not to say that if inflation is under control then there will be no price increases. The rate of increase will just be slower.
While there is no consensus about what causes inflation, it is believed that it is linked to employment. As employment rises, so does inflation. And as inflation rises, so do interest rates. Moderate inflation is natural in a growing economy. An economy functions most efficiently when inflation is low.
The problem with inflation lies not so much in the fact that it rises, but in the fact that it is unpredictable. If it was predictable, we would be able to plan ahead and build price increases into our financial reckonings. Inflation causes damage because it catches us unprepared. Price increases take us by surprise, economic efficiency is reduced and consequently we lose confidence in our currency, creating a further deterioration.
Though inflation increases are generally unpredictable, there are ways to minimise the damage. Assess the effect of rising inflation and in turn rising interest rates on monthly bond payments.
Examine your debt. Ironically, inflation is good for you if you have a lot of fixed-rate debt, such as home, equity or car payments because the value of the money you owe is less in an inflationary environment. To benefit most from an inflationary environment, you might want to exchange your variable-rate debt (eg. credit cards) for fixed-rate debt.
Sometimes it is evident that a rise in inflation is imminent. In this case you should adjust your investment portfolio accordingly. Since stocks and bonds suffer from an inflationary environment with rising interest rates, you may want to consider buying an inflation-protected bond. These automatically pay more as inflation rises.
Though inflation is unpredictable, it is important to keep watch by keeping an eye on rising prices and at what speed they occur. That way you'll get an indication of the direction in which things are moving. You can't predict the future, but forewarned is forearmed.
l The writer is a director of Pioneer Financial Planning. Visit www.pioneer.co.za or e-mail email@example.com