Inflation is an interesting concept that more average people are starting to become very concerned about at the time of this writing (January 2022). In a monetary sense, inflation is the increase in the money supply that is it. However, it is commonly used to refer to an increase in prices in a good, service, or asset. This is because increasing the money supply in the real economy causing more currency units (dollars) to chase the same amount of goods and services. It is important to note that consumer prices (goods and services) and prices of financial assets tend to be driven by some different factors, so it is important to think of them separately. So how does inflation affect a household? Inflation will affect people differently depending on where they are in the financial system: bank, business, government, employee, etc.
A side note I would like to make is when you are talking about prices and the strength of a currency it is important to know COMPARED TO WHAT. The dollar can be falling on the DXY, but consumer price inflation is rampant. People are so used to using dollars for everything that they forget you can trade almost everything. For example, home prices compared to gold.
Disadvantages of Inflation
The fundamental disadvantage of inflation is the decrease in purchasing power each currency unit possesses. Essentially, one currency unit (dollar) can buy less and less goods and services as inflation continues.
Here is a chart of the purchasing power of the US dollar courtesy of Visual Capitalist. I love this website for many reasons. This link is to the page where I got this photo, but they have a bunch of other really great graphics. https://www.visualcapitalist.com/purchasing-power-of-the-u-s-dollar-over-time/
As you can see, how much the US dollar can purchase has significantly decreased since the Federal Reserve system was created. With $1 from 1913 being equivalent to $26.14 as of 2020. This is what happens with inflation and why it is important for people to understand how it works and how it affects their lives. As can be seen in the bottom of the figure, inflation causes prices to rise, meaning you can buy less and less with your money. By the way, the purchasing power of $1 in 2020 is 3.8% of the purchasing power of $1 in 1913. That’s inflation…
So, what else happens with inflation? Something called Gresham’s law kicks in. Gresham’s law states that bad money will chase out the good money. An example of this is when the United States started to take out the silver within their coins and replacing it with other metals. People naturally understood that the money was less valuable so they would hoard the silver and only spend the fiat (fake) money. This is generally the first step to inflation because the money is then fiat, meaning there is no intrinsic value in the physical metal that the government can’t just create more of. This is why gold has been used as currency and a store of value for over 5000 years, governments cannot print gold because gold is scarce. Nickel, on the other hand, is not, so they mint coins with nickel, zinc and other metals that are relatively plentiful when compared to gold.
Once inflation starts to take off, people will start buying goods and services that have tangible value and will store them. They know that the price of those goods will increase in the near future, so they buy up now which leads to shortages. This major change in human behavior is due to a change in psychology of the masses. Even average people are noticing that their grocery bills are increasing more and more while the shelves are becoming empty.
Just to make matters worse, real wages rarely keep pace with inflation. Real wages reflect the purchasing power of your wage (nominal wage – inflation). This information is normally published as rates. When you hear inflation, it is normally stated as a percentage, it is the inflation RATE. Maybe it’s the physicist coming out of me, but the difference between a rate and just a plain value is important. A 5% increase in the price of chicken isn’t too big of a deal (from $2/lbs. to $2.10/lbs.), especially when compared to a 5% increase in the price of a house ($300,000 to $315,000). Also note how rates are compounded, so the next inflation rate would be for the new starting price of $315,000 for the house example. As you can see, this can quickly get out of hand.
Advantages to inflation
Decreasing the purchasing power of the cash you keep in a safe or your bank account isn’t only negative. Keep in mind that money is half of every transaction in modern times. When you go to the store, they give you food and you give them money in return, therefore, the purchasing power of the money is decreasing in every single one of these transactions. So how can you benefit?
Debt.
Inflation induced debt destruction, a term said by Jason Hartman, a residential real estate expert. Yes, inflation does reduce the value of the dollars in your bank account, but that also means that you are paying back your debt with devalued dollars as well. This is for FIXED rate debt, not necessarily for adjustable-rate debt depending on the interest rate. What is amazing is when your interest rate, say on a fixed rate mortgage is 3%, which seems typical for prime borrowers these days, at least where I am, and the inflation rate is above 7% (or so the government tells us, it is well known that they tailor the CPI to show a depressed inflation rate). This means that there is a 4% spread between the purchasing power of what you are paying the bank and the purchasing power of your dollars compared to goods and services you would buy in the real economy at least on average. There is a TRANSFER of wealth from the bank TO you (the borrower). This is one benefit from high inflation rates, at least if the inflation rate is above that of your interest rate on fixed rate debt. This doesn’t mean it’s a good idea to run up those credit cards. Remember, it is the fact that the inflation rate is higher than the interest rate on your mortgage/fixed rate debt.
So how do you protect yourself from inflation?
Inflation is really just a spread, the spread between nominal values (wages, prices, GDP, etc.) and real values. The real version of data is what reflects your purchasing power. So, when you want to protect yourself against inflation, you are really just wanting to preserve your purchasing power. This means that if inflation is at 7%, you need to get at least a 7% return on whatever you do with your money, but that is extremely difficult to do in risk-adjusted terms today.
Above is a graph of the risk curve. It shows the amount of return you should expect relative to the amount of risk you assume. So, government bonds are believed (at least by the masses) to be one of the assets of the lowest risk. As of this writing the 10-year treasury bond is trading around 1.8%. Notice how much lower this is of the CPI of 7%. This means that the purchasing power of your bond is -5.2%. Negative real yields are basically stealing purchasing power from you because cannot personally do anything about inflation. This is why some people refer to inflation as a tax. It’s like taxing 5.2% of your income, just because you are using the dollar as your currency.
Since you cannot single-handedly bring down the inflation rate, you can only control the yield you get from your investments, and as you can see on the risk curve above, if you want to achieve a higher yield, you need to assume more risk. This is probably one reason why people are throwing a bunch of money in cryptocurrencies and NFTs as an example. I am not saying it’s a bad idea, if you understand the market and what you are dealing with, then it’s a great idea. My point is that there are a lot of people throwing their savings into these markets just in hopes of the price increasing so much that their yield outruns the inflation rate. That is probably not a good idea. Risk is a function of the investor as well. If you do not spend the time to actually learn the asset class and become an expert, you are just hoping and gambling that you will make money. Stocks are that risky for Warren Buffet because he has spent literal decades learning and becoming an expert in them and businesses. Stocks are most likely significantly riskier for you relative to how risky they are for Warren Buffet, unless you are one of the few people who make more than him.
Conclusions
To recap, monetary inflation is the increase in the money supply. However, the term inflation is more prominently used to describe an increase in prices for goods, services, and financial assets. The prices are increasing because there are more currency units in the real economy chasing goods and services, essentially bidding up the prices. This decreases the purchasing power of the money you already have, so people tend to start buying as much as they can to stock up on certain goods, especially when the inflation becomes more noticeable to the average person, courtesy of their grocery bill increasing consistently. However, if you owe any fixed rate debt, like a fixed-rate mortgage, you are paying back that loan with devalued dollars, and if the inflation rate is larger than your interest rate on your mortgage, some of the purchasing power of the lender is transferred to you, the borrower. So, it is important to understand why inflation is occurring because then you can make sure you are on the correct side of that transaction, where purchasing power is being transferred to you instead of being taxed out of your bank account in a hidden way.
To your wealth and future,
James Forsythe
For more macro topics
https://jamesdforsythe.com/category/finance/macro/
https://jamesdforsythe.com/macroeconomics-and-why-it-is-important/
