Thursday, 21 February 2013

Part 1 : Do You Really Know What Inflation Is???

One of the most common term used when it comes to financial planning, investment or financial freedom is "Inflation Rate". While many of us do not understand how the inflation rate is obtained, we tend to read or hear the following:

  1. For investors, we must make sure that our % investment return per year must be higher then inflation rate.
  2. For consumers, our money is getting "smaller" every year due to inflation, hence our purchasing power becomes weaker every year.
  3. For personal financial planning, inflation is taken into consideration when it comes to ensuring that the money we save/invest grows faster then the inflation rate.
  4. For salary earners, we complain about our salary increment is lower then inflation rate. 
While we speak as if we know inflation like the back of your hands (but only know "tiga suku" about it), I intend to share my own findings about inflation in today's post. 

What is Inflation?

In actual definition, "inflation" is the shortened term for "Price Inflation" or increase in price. Vice versa, inflation also has an opposite called "deflation" or "price deflation". 

What kind of price are we referring to? 
The "price inflation or deflation" which we refer too are the movement of prices for consumer related goods and services. It's pretty logical when you look back at point 2, continuous price inflation every year will shrink our purchasing power. Hence we tend to hear complains such as;

"Those days ah...I can buy nasi lemak for 10cents, now I need to pay RM2.00 for a packet"

all the time!

Who monitors the movement of prices?
The movement of consumer related goods and services are monitored on a monthly basis in which a report called Consumer Price Index report is then generated by the Department of Statistics, Malaysia. Yeap, I just found out today that we have our own statistic department that reports directly to the prime minister! 

Ironically, the head of the Statistics Department is called Chief Statistician!
Dr. Haji Abdul Rahman HasanChief StatisticianMalaysia 

What is Consumer Price Index?
The Consumer Price Index (CPI) Malaysia measures the percentage change through time in the cost of purchasing a constant basket of goods and services which represents the expenditure pattern of all households in Malaysia in a specified time period. It is calculated based on the international standard and procedures; known as the Laspeyres formula. 

 "Index" in this scenario refers to a reference value where the current prices of goods and services are benchmarked against. As of present, the benchmark value used for comparison is the price of goods and services in the year 2010. 

For example:
The price of Item A in 2010 is RM2.00. Therefore Item A at RM2.00 in 2010 is assigned a benchmark CPI value of 100. 

Say in 2013, item A is sold at RM2.50, an increase of RM0.50 from the price in 2010. Therefore the percentage change is: (RM0.50 / RM2.00) x 100% = 25%

A 25% increase in Item A from 2010 to 2013 will give Item A a CPI value of 125.

Categories that makes up Malaysia Consumer Price Index
Item A above is just one of the 460 items (goods & services) monitored. All 460 items are group accordingly into 12 important categories, each with separate percentage size as shown below
  1. Food & Non-Alcoholic Beverages - 30.3%
  2. Alcoholic Beverages & Tobacco - 2.2%
  3. Clothing and Footwear - 3.4%
  4. Housing, Water, Electricity, Gas & Other Fuels - 22.6%
  5. Furnishings, Household Equip. & Routine Household Maintenance - 4.1%
  6. Health - 1.3%
  7. Transport - 14.9%
  8. Communication - 5.7%
  9. Recreation Services & Culture - 4.6%
  10. Education - 1.4%
  11. Restaurants and Hotels - 3.2%
  12. Miscellaneous Goods & Services - 6.3%
Therefore, if prices of items in a major category such as "Food & Non-Alcoholic Beverages" goes up, the overall Consumer Price Index for Malaysia will also increase drastically and vice versa.

Overall Consumer Price Index for Malaysia
While we need not be overly concerned about the details of each of the 12 categories, we do need to look at the overall Consumer Price Index movement for Malaysia. The movement of overall CPI, normally stated in % increase or decrease, tells us if the price of goods and services that we use are:
  • increasing or decreasing
  • the rate of the price of goods increasing or decreasing
Let's take a look at this report from theStar dated 20 Feb 2013 below:

In the article, it states that "the inflation rate, measured by the consumer price index (CPI) increased to 105.9 from 104.5 a year ago".

From the statement about Malaysia CPI, we should now be clear on the following:
  1. The CPI benchmark is at 100 (using 2010 as reference)
  2. In January 2013, the CPI is at 105.9
  3. In January 2012, the CPI is at 104.5
  4. The increase in CPI is 1.4 points from Jan 2012 to Jan 2013
  5. The % increase in CPI is 1.3% approximately from Jan 2012 to Jan 2013
Relating CPI with Inflation
If you remember earlier in this post, we defined inflation as "price inflation" or "price increase". The rate of price increase or decrease is then measured via Consumer Price Index. Hence an increase in the Malaysia CPI, indicates that our country is experiencing inflation  A decrease on the other hand means that our country is experiencing deflation. 

Understanding Inflation Rate
While most countries in the world are experiencing inflation, what separates one country from the other is the inflation rate. The rate of inflation is derived on year to year basis utilizing the Consumer Price Index value

Here's an example:
Country A CPI as of 31 Dec 2011 : 104.0
Country A CPI as of 31 Dec 2012 : 105.9
Difference in CPI : (105.9 - 104.0) = 1.9
% Increase in CPI between 31 Dec 2011 to 31 Dec 2012
: (1.9 / 104.0) *100% = 1.83%

A 1.83% increase in CPI between 31 Dec 2011 to 31 Dec 2012 is in fact the inflation rate for Country A for the year 2012.

I believe that the basic meaning of inflation should be covered by this post. It does sound a little long winded, but should be easy enough for readers to understand. There will be a part 2 post on this topic which I will get it up in a few days. I hope you've enjoyed reading this post about inflation.

Even chickens hope for high inflation.
Well higher prices equals lesser spents on meat.
Cheers and Happy Investing!

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  1. Hi, I would like to highlight to the rest on the big percentage of the CPI reflected by these 3 categorires below:

    Food & Non-Alcoholic Beverages - 30.3%
    Housing, Water, Electricity, Gas & Other Fuels - 22.6%
    Transport - 14.9%

    Total weightage: 67.8&%

    With that in mind, we know that our government is heavily subsidizing these categories, and this would actually supress the actual inflation in such areas in comparison with the rest of the world.

    When the government is subsidizing these and inflation cont to beat in, it equals to more/higher spending from the government coffer. Thus, the 1.83% inflation isn't the actual inflation rate as the Gov has absorbed the rest of the inflation by using the country/public coffer and loans.

    In a simplest summary, it would mean that your RM would only be sustainable in Malaysia but not when you are oversea. Bear in mind that we are talking about world without border. Can we continue to rely on such inflation index reporting?

  2. Spot on AdCool about the subsidy as i was going to highlight that in part two. In terms on government subsidy, it depends on how we look at it. the subsidy can be looked at a positive and negative perspective as well as how each individual intepret the subsisdy initiative by our government.

  3. Great explanation 'Chief Statistician'! Aha, even chickens hope for high inflation! Now wonder inflation rate in Malaysia looks uncertain.