Most of us know what inflation is - at least we think we do. If you ask the average lay-person to define inflation, they would likely say something about rising prices. This is correct, at least in the colloquial use of the term. What these people are actually defining is price inflation. Inflation, without the modifier, is defined as an increase in the money supply.
It’s easy to confuse the two because they are related. When the money supply is increased it typically causes increases in prices. The reason for this is quite simple. The amount of goods and services in such a scenario remains roughly the same. The supply of money, however, increases. There is more money chasing a finite amount of goods and services, the amount of which has not increased relative to the money supply. This will cause those who have access to that new supply of money to bid higher for those limited goods and services and will also signal that each dollar is not as valuable as they were prior to increasing the money supply.
As you can see, increasing the money supply in this example increases prices directly. This is not a 100% guaranteed relationship, as there are many other factors in play in an economy. Additionally, the relationship is not equal across all products or industries. For example we’re seen an increase of 35% in used car prices, a 32% increase in energy costs and a nearly 9% increase in food costs, all while the year-over-year inflation rate for March 2022 is 8.5%.
Why is Inflation Not Consistent Across Categories?
Inflation is not consistent across the board because it doesn’t impact all industries in the same way. Some products may be impacted to a greater or lesser degree by an increase in input costs, say fuel for example. Different industries also have to contend with their ability to raise prices before consumers seek alternatives or abandon the product entirely. This last point is referred to as elasticity in economics and can be thought of as how likely you are to continue to buy a product in the face of rising costs.
For example, if you like drinking cola and you prefer Coke to Pepsi. At some point, if Coke begins to raise prices while Pepsi does not, some percentage of their client base will switch to Pepsi while others may opt for coffee or even water. For you, it may be a large of small change in the price of Coke that causes you to make a change. This will be based on how much you like Coke, how sensitive you are to increasing prices and the availability of alternatives.
Critical industries, those without alternatives, or those that cater to people less impacted by price - think luxury goods - may have little to no loss in sales even with a substantial increase in price. Other industries, ones that have many alternatives, are more discretionary in nature, or are consumed by very price-conscious consumers are less likely to increases prices until, and unless, absolutely necessary.
What is the Cause and Who is to Blame?
If you’re looking to point the finger at the individuals and organizations behind the current inflation we are experiencing, a good place to start is Washington DC. The constant meddling of Congress, the executive branch, the Federal Reserve (Fed) and the Treasury department in various aspects of the economy is what has ultimately brought us to the point we are currently at.
Congress, for their part, has no incentive to limit spending - after all promising new programs helps with getting re-elected. The same goes for the executive branch. The Fed is trying to keep rates low lest we default on our debt and no one wants to be the first to dare suggest we tighten our belts.
It’s easy to point to the increase in money supply as the sole cause - specifically during the last 2 years - of our current inflation. It is certainly to blame, but is not the only reason. We’ve been increasing the money supply for years - every time there is a crisis we throw money at the problem. This approach never worked and merely pushes the eventual reckoning further into the future. Regardless of who is in the oval office or what party controls Congress, the printing presses never stop - and sometimes they even work overtime.
In the case of the trillions of dollars in Covid-19 spending, much of it was misappropriated, which should come as a shock to absolutely no one. Emergency payments were sent to fraudsters, many of which were not even in the United States, while Americans in need waited and hoped for help that in some cases never came. The end result is inflation without much, if any, of the supposed benefits these payments were supposed to achieve.
Our interest rates have been low for far too long, with the Fed not being keen on raising rates for fear of toppling an economy that is not on sure footing. Low interest rates lead to speculation, particularly in things like housing - a lesson we should have learned more than a decade ago with the housing collapse, but didn’t. Rates that are too high would potentially cause the US to be unable to service their debt payments, and would force Congress to be more judicious with their spending - something hardly in DC is willing to talk about, much less act on.
Misguided Scapegoats
When you’re in the wrong it is much easier to point the finger at someone or something else than it is to admit and correct our errors.
Some people like to point the finger at corporate America and claim they are greedy and that’s the cause of inflation. These are people who clearly prefer a sound bite to sound monetary policy. Greed is a natural human trait - not a good one, but a natural human one nonetheless - it is only through free and transparent markets that we can get what we need and want from these “greedy” capitalists because they have to provide us with value so that we trade our hard earned money for their products. Regardless of how greedy someone is, if we are not willing to trade our money for their products, they will not profit - unless government intervenes - and intervene they have.
Additionally, greed is not something that comes and goes. It’s ridiculous to assert that the same corporations were benevolent and willing to forego profit until they suddenly learned of greed recently.
Vladimir Putin is another person who is all to easy to blame for our inflation woes, and while he does have a role to play in this entire scenario, it is minuscule compared to the damage we’ve done to ourselves.
Putin is far from the leading cause of our inflation problem, which was well underway before he invaded Ukraine. Our actions in response to Russia have basically ensured that food and energy costs will continue to remain high and possibly even increase in the near term.
Food and energy costs are some of the largest expenses Americans have outside of their homes and cars. Russia is a large product of grain, oil and fertilizer. Ukraine is also a large grain producer. Even if we don’t necessarily import these goods directly, any impact on production and distribution is likely to be felt in the form of prices. In some cases, even if there is no impact, the expectation there could be may be enough to cause higher prices than what we are used to.
Most reports are that the Russian military is avoiding destroying Ukrainian fields, but that doesn’t mean farmers are there to plant, and ultimately harvest them, in such an uncertain environment. Russia being a major producer of fertilizer means that costs of farming worldwide will be higher as fertilizer will be in short supply and yields potentially may be much lower and driving prices higher.
Most interestingly is Russia’s response to the United States’ sanctions, which have pegged the Russian Ruble to gold and encouraged Saudi Arabia and other oil rich countries to consider selling oil for something other than US Dollars. The petro-dollar has long been one of the few things allowing the US to mismanage its economy and spend as recklessly as it has. Should the dollar cease being the default currency for oil our inflationary woes are bound to get worse and the dollar loses its reserve currency of the world status.
What Can You Do To Combat Inflation?
It should be clear at this point that inflation is bad for nearly all consumers. If you have savings held in cash you are losing purchasing power as inflation increases. The higher the level of inflation, the more purchasing power you lose by holding cash and short term securities.
There are numerous historical examples of what happens when inflation gets really out of hand. Search for Zimbabwe, Venezuela and the Weimar Republic as just a few cautionary tales.
While the inflation we’re experiencing now is certainly not on the level of the examples above, we cannot continue ignoring the problem. Our debt as a nation is too high and Congress continues to spend like drunken sailors, ensuring the Fed won’t be able to raise rates too high. At a certain level we won’t be able to afford to pay the interest on our outstanding loans.
Sadly, there is little you as an individual can do to stop or turn back inflation. The best we can do as lay-people, without access to the levers of the economy, is to protect the purchasing power of the dollars that we hold.
Protecting our purchasing power means investing in things that meet or exceed the rate of inflation. This is no easy task considering there is no cap on inflation and no guarantee that stocks, gold, bitcoin, land or other assets will keep pace with inflation going forward, even if they have done so in the past.
Unfortunately high inflation hurts savers more than it does spenders. A spender buys goods and services as soon as they can, while a saver put money away until it’s needed, at which point the price may be significantly higher.
With interest rates still being near all time lows, inflation also tends to benefit borrowers over those who save. Paying 5% interest on a loan for something that is appreciating at 10% is quite a deal if you can get it. Particularly if you pay over time and the loan amount and rate is fixed, while the value of the dollars used to pay down the debt continues to decrease.
While immediately spending you emergency savings account and buying assets as an inflation hedge might sound like a good idea, it’s definitely not. Most of us recognize that having some cash on hand is necessary to cover unexpected emergencies even if it means purchasing power is lost over time. Also consider that some assets may take time to sell - such as land or homes - and their prices, like those of stocks, gold, bitcoin and other things traded on exchanges fluctuates up and down and does not follow inflation in a straight line. You don’t want to find yourself in a situation where you have to sell low because you need the cash.
Contact your financial advisor to craft a specific plan that helps you maintain some purchasing power while also giving you enough cushion in your finances should you need it.