Inflation is when the money in your pocket lose its purchasing power. It could be a result of the money supply has dramatically risen or product prices have surged.
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 unit of currency may allow buyers to purchase less than it did in prior periods. Inflation 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, huge quantities of gold and 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 as a result of the money supply’s fast expansion, which helped to fuel the inflation of product prices.
The opposite of deflation, which occurs when the inflation rate falls below 0% and implies a widespread reduction in prices for goods and services. Inflation is measured in a variety of ways based on the sorts of commodities and services taken into account.
What causes inflation?
Economists like to categorize the 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 which could include both higher wages or material prices. Companies pass along those higher expenses by raising prices, which then cycles back into the cost of living.
On the flip side, demand-pull inflation generates price increases when consumers have resilient interest for service or goods.
Demand could result from things like a low-employment rate, a high-saving rate, or strong consumer confidence. Higher products 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:
- Creating new money and distributing it to people
- Decreasing the value of the legal tender money in a legal manner
- 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 main and most significant impact of inflation. A general increase in prices over time diminishes customers’ purchasing power because a constant quantity of money will eventually contribute less consumption. Whether inflation is running at 2% or 4%, consumers still lose purchasing power; the higher inflation rate only 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 a greater percentage 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 modest inflation since this helps the economy function, gives room for error in the event that 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 as mentioned above. Over the past century, monetary policy has been used to control inflation in the United States and throughout the world. Policymakers can increase the minimum interest rate to raise borrowing costs throughout the economy 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, while 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 issue with the trade-off between inflation and unemployment is that, it 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 do well
Bonds are often lower-risk investments that offer consistent interest income at a fixed rate. By reducing the present value of that income, inflation, and particularly significant inflation, it may depreciated 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 rising rents, even while inflation reduces the real 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 stocks of commodities, may like to see inflation since it increases the value of their possessions, which they can then sell for more money.
Due to the expectation of higher returns during the inflation, firms and individuals who invest in company stock frequently speculate on riskier ventures as a result of inflation. In order to encourage spending to some extent rather than conserving. An ideal level of inflation is frequently suggested. A larger 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 an economy. People believes 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 true value of their possessions. Thus, those wishing to hedge their portfolios against inflation should think about investing in commodities, real estate investment trusts, gold, and other inflation-hedged asset classes (REITs).
High and erratic inflation rates can have a significant negative impact on an economy. Businesses, workers, and consumers must all account for the effects of typically rising prices in their purchasing, selling, and planning decisions. Because they might make a mistake in estimating the rate of future inflation, this adds another source of uncertainty to the economy.
Top 10 Countries with the Highest Inflation Rates (Trading Economics Jan 2022)
- Venezuela — 1198.0%
- Sudan — 340.0%
- Lebanon — 201.0%
- Syria — 139.0%
- Suriname — 63.3%
- Zimbabwe — 60.7%
- Argentina — 51.2%
- Turkey — 36.1%
- Iran — 35.2%
- 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 that is known as an economic crisis.
Inflation and the Fed
The Federal Reserve need to keep inflation at a steady level. The Fed Open Markets Committee (FOMC) has established that for the best employment and price stability, an inflation rate of roughly 2% is ideal.
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, so boosting the economy. As a result of lower interest rates, people get less income on 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, a lot of individuals have considered gold to be a “alternative currency,” especially in nations where the national currency is depreciating. When their own currency fails, these nations frequently use gold or other stable currencies. 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 the greatest upside potential. Businesses with low capital requirements typically benefit from inflationary trend.
- Real Estate Income
Real estate income is income earned from renting out a property. Real estate works well with inflation. This is due to the fact that as inflation increases, property prices also climb, which raises the maximum rent demanded by a landlord. As a result, the landlord gradually earns a bigger rental revenue. This aids in limiting the rate of inflation increase. Real estate income is therefore one of the most effective strategies to protect an investment portfolio against inflationary trend.
Advantages and Disadvantages of Investing for Inflation
Every type of investment hedging has advantages and disadvantages, just like every type of 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 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 both asset-growth and inflation-fighting methods.
Advantages
- Maintaining portfolio value
- Expanding your possessions
- Keeping your purchasing power constant.
Disadvantages
- Increased risk exposure
- Distancing from long-term objectives
- 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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Source: Investopedia