Learning Inflation: Important Causes and Effects to Know

It’s an economic phenomenon that negatively affects policymakers, investors, and consumers alike. That is more true now than ever because costs are rising on practically everything Americans buy, such as furniture, food, fuel, or automobiles, according to data from the bureau of labor.

What is Inflation?

Inflation is the decline of purchasing power of a given currency over time. The increase in the average price level of particular goods and services over time in an economy can contribute a quantitative approximation of the rate at which the reduction in buying power happens.

The rise in prices is often shown as a percentage. A currency unit may allow buyers to purchase less than they did in prior periods. Inflation is contrasted with deflation, which happens when the purchasing power of money grows, and product prices drop.

Theoretically, the popular theory of monetarism explains the relationship between inflation and the money supply of an economy. For instance, vast quantities of gold, particularly silver, poured into the economies of Spain and other European nations after the Spanish conquest of the Aztec and Inca empires. The value of money decreased due to the money supply’s fast expansion, which helped fuel the inflation of product prices.

The opposite of deflation occurs when the inflation rate falls below 0% and implies a widespread price reduction for goods and services. Inflation is measured in various ways based on the sorts of commodities and services considered.

What causes inflation?

Economists like to categorize typical inflation causes into two categories: demand-pull and cost-push inflation. They sound wonky, but they reflect experiences that many Americans are familiar with.

Cost-push occurs when prices increase because production is more expensive, including higher wages or material prices. Companies pass those higher expenses by raising prices, which then cycles back into the cost of living.

Conversely, demand-pull inflation increases prices when consumers have resilient interest for services or goods.

Demand could result from low unemployment, high saving rates, or strong consumer confidence. Higher product demand causes companies to produce more to keep up with demand. This could lead to product shortages and price surges.

Though it may manifest through other economic mechanisms, a rise in the money supply is the primary cause of inflation. The monetary authorities can boost a nation’s money supply by:

1. Creating new money and distributing it to people
2. Decreasing the value of the legal tender money in a legal manner
3. Buying government bonds from banks on the secondary market, creating new money as reserve account credits through the banking system (the most common method)

Effects of Inflation

Decrease in Purchasing Power

This is the primary and most significant impact of inflation. A general price increase over time diminishes customers’ purchasing power because a constant quantity of money will eventually contribute to less consumption. Whether inflation runs at 2% or 4%, consumers still lose purchasing power; the higher inflation rate doubles that loss. If long-run inflation doubled, compounding would ensure that the aggregate price level would rise more than twice.

Disproportionately harms the poor.

Consumers with lower salaries typically spend more of their total income on needs than those with higher incomes. Leaving them with less safety net against the erosion of purchasing power brought on by inflation.

Prevents deflation

order to fulfill its goals for stable prices and maximum employment. The Federal Reserve aspires for inflation of 2% over the long term. Instead of aiming for constant prices, it aims for modest inflation since this helps the economy function, gives room for error if inflation is overestimated, and prevents deflation, which can be far more destabilizing than equivalent inflation.

Increased Interest Rates

Governments and central banks have a strong motive to control inflation, as mentioned above. Over the past century, monetary policy has been used to control inflation in the United States and worldwide. Policymakers can increase the minimum interest rate to raise economic borrowing costs by limiting the money supply when inflation threatens to surpass a central bank’s target (usually 2% in industrialized economies and 3% to 4% in emerging ones).

Lowers the cost of debt service

While individuals with fixed-rate mortgages and other loans gain from repaying these with inflated money, cutting their debt service costs after accounting for inflation. At the same time, new borrowers are likely to incur higher interest rates when inflation rises.

Increases employment and growth in the short term

Short-term economic growth can be accelerated by rising inflation. For example, the U.S. real Gross Domestic Product (GDP) rose 3.2 percent year on average between 1970 and 1979, well above the economy’s average growth rate subsequently. However, the 1970s are remembered as a decade of stagflation.

Possible Lead to Painful Recessions

The trade-off between inflation and unemployment may be the same incident that happened in the United States during the stagflation of the 1970s. A prolonged acceptance of higher inflation to protect jobs may cause inflation expectations to rise to the point where they trigger an inflationary spiral of price hikes and pay increases.

Bonds suffer, while stock growth does well.

Bonds are often lower-risk investments that offer consistent interest income at a fixed rate. Reducing the present value of that income, inflation, and particularly significant inflation, may depreciate the value of bonds.

Boosted Value of Real Estate, and Energy Stocks

Real estate has long been used as a buffer against inflation because landlords can do so by raising rents, even while inflation reduces the actual cost of fixed-rate mortgages.

Advantages and Disadvantages of Inflation

Depending on the position one chooses and how quickly the shift occurs. Inflation can be viewed as either a good or a bad thing.

Advantages

People who own tangible assets that are valued in their native currency. For example, real estate or commodities stocks may like to see inflation since it increases the value of their possessions, which they can sell for more money.

Due to the expectation of higher returns during inflation, firms and individuals who invest in company stock frequently speculate on riskier ventures due to inflation. To encourage spending to some extent rather than conserving. An ideal level of inflation is frequently suggested. A more considerable incentive to spend now rather than saving and spending later may exist if the buying power of money decreases with time. Spending could rise as a result, which would help the economy. People believe this strategy can keep the inflationary trend rate in an ideal and acceptable range.

Disadvantages

The fact that people will have to pay more money due to inflation may not make buyers of these assets happy. Inflation may not be pleasing for those who own assets denominated in their native currency, such as cash or bonds, as it reduces the actual value of their possessions. Thus, those wishing to hedge their portfolios against inflation should consider investing in commodities, real estate investment trusts, gold, and other inflation-hedged asset classes (REITs).

High and erratic inflation rates can significantly negatively impact an economy. Businesses, workers, and consumers must account for the effects of typically rising prices in their purchasing, selling, and planning decisions. Because they might make a mistake in estimating the future inflation rate, this adds another source of uncertainty to the economy.

Top 10 Countries with the Highest Inflation Rates (Trading Economics Jan 2022)

1. Venezuela — 1198.0%
2. Sudan — 340.0%
3. Lebanon — 201.0%
4. Syria — 139.0%
5. Suriname — 63.3%
6. Zimbabwe — 60.7%
7. Argentina — 51.2%
8. Turkey — 36.1%
9. Iran — 35.2%
10. Ethiopia — 33.0%

Venezuela currently has the highest inflation rate in the world, with a recent increase to almost one million percent. Prices in Venezuela have occasionally changed so quickly that shops stopped labeling goods with prices and instead advised consumers to ask staff what each item was that day. A government overspending and printing significant amounts of additional money to cover its expenditures typically lead to hyperinflation. A level of runaway inflation is known as an economic crisis.

Inflation and the Fed

The Federal Reserve needs to keep inflation at a steady level. The Fed Open Markets Committee (FOMC) has established that an inflation rate of roughly 2% is ideal for the best employment and price stability.

This level of inflation gives the FOMC scope to jump-start the economy during downturns by decreasing interest rates, which makes borrowing cheaper and helps boost consumption. Lower interest rates make borrowing money more affordable for consumers and businesses, boosting the economy. As a result of lower interest rates, people get less income from their savings, which encourages them to spend. However, all of this additional demand may raise inflationary trend.

What Investments Beat Inflation?

• Gold

Gold has frequently been regarded as an inflation hedge. In reality, many individuals have considered gold an “alternative currency,”, especially in nations where the national currency depreciates. These nations frequently use gold or other stable currencies when their currency fails. Since it is a genuine, physical asset, gold often retains its worth.

• Commodities

Commodities are a broad category that includes grain, precious metals, electricity, oil, natural gas, foreign currencies, emissions, and other financial instruments. A special relationship exists between commodities and inflation, whereby commodities can predict future inflation. A commodity’s price increases together with the cost of the things it is used to create.

• The S&P 500

In the long run, stocks have tremendous upside potential. Businesses with low capital requirements typically benefit from inflationary trends.

• Real Estate Income

Real estate income is income earned from renting out a property. Real estate works well with inflation. This is because as inflation increases, property prices also climb, which raises the maximum rent demanded by a landlord. As a result, the landlord gradually earns an enormous rental revenue. This aids in limiting the rate of inflation increase. Real estate income is one of the most effective strategies to protect an investment portfolio against inflationary trends.

Advantages and Disadvantages of Investing in Inflation

Every type of investment hedging has advantages and disadvantages, just like every investment. The numerous assets mentioned above each have advantages and disadvantages.

Naturally, maintaining the value of your portfolio is the main advantage of investing during the inflationary trend. Your desire to maintain the growth of your nest egg is the second justification. Additionally, it might encourage you to diversify, which is always a good idea. A tried-and-true way of building a portfolio is to spread the risk among many holdings, which may be used for asset-growth and inflation-fighting methods.

Advantages

1. Maintaining portfolio value
2. Expanding your possessions
3. Keeping your purchasing power constant.

Disadvantages

1. Increased risk exposure
2. Distancing from long-term objectives
3. A portfolio that is too heavy in some classes

However, investment should never rely solely on inflation. You shouldn’t deviate from your investing plan’s precise objectives or timelines if you have any. For instance, if your portfolio needs large capital growth, don’t overly rely on TIPS. Additionally, if you are about to need retirement income, avoid purchasing long-term growth stocks. You should never venture outside of your risk tolerance comfort zone due to a fixation with inflation. Traditional inflation hedges don’t always work, and unusual economic circumstances may produce fantastic results for unexpected assets.

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Read more: Economies

Source: Investopedia