Kassandra Learn: What is inflation? (Part 1)
In a nutshell…
Often referred to as the silent or invisible thief, inflation describes the decrease in value per unit of currency. In addition to our current purchasing power, this loss of value affects all our past savings and investments literally making them worth less than they were before. We can see inflation at work in our day to day lives when prices rise and value drops. This means that while getting a raise may increase our earnings, if increases don’t keep up with the pace of inflation then we actually have less purchasing power than before!
But what is inflation? Why does it happen? And what can we do to protect ourselves from this “invisible thief”?
How Inflation Works
In any modern economy where consumer demand rules the market, prices can rise and fall for many reasons: availability of goods, increases in efficiency, lack of demand, seasonality, etc. Inflation on the other hand is what happens when the prices of all goods and services increases across the board.
Inflation reduces the value of currency over time. That means that $1 today is worth less than $1 last year, last month, or even yesterday.
We don’t often see inflation across all goods and services. Inflation is usually most obvious to consumers in fuel, food, energy, and rent, but some price changes are felt more than others. We quickly notice an increase in the price at the gas pump or in our energy bills, for example. However, even less obvious rises in the price for basic consumer goods eventually have us feeling the pinch.
If that feels unfair to you, you’re not alone. When inflation takes a heavy toll, its always a herald of financial vulnerability but political instability too. Bankers and politicians want to be seen as “tough” on uncontrolled inflation, as well as the things seen to increase it (such as government spending and monetary policies that affect the money supply). Voters response at the ballot box can be punishing if they fail. However, ass we’re going to see it isn’t in the interest of politicians to do away with inflation entirely.
What Causes Inflation
Increases in wages seldom keep up with the pace of inflation. An increase in overall prices means an increase in the cost of living and a decrease in the quality of life. This impact on quality of life can be harsh, affecting the poorest much more that those with a comfortable buffer of savings and income.
However, even those who are relatively well off can find that comfort eroded in a time of crisis. Housing expenses, like mortgages and rent, can leave people without a home and, as we saw in the financial crisis of 2008, that doesn’t take very long at all. But how does this happen? And is there anything we can do to prevent runaway inflation?
Many economists identify historic periods high inflation as coming from poor monetary policy. If too much money is printed or produced compared with the actual value or size of an economy, the money is worth less as it represents a lower amount of social value. Another way to refer to this is as the quantity theory of money and it’s one of the fundamental principles of economics.
If that sounds complex, don’t worry. The concept is something you probably already understand without thinking about it. Consider a very simple thought experiment: what if we were all paid $100,000 an hour, regardless of our position or work output? And since that would take a huge amount of cash, what if the government printed more money to make this possible? You can probably guess what would happen: the price of everything would rise dramatically and the “worth” of our money would be devalued to the point where this kind of universal raise would be meaningless.
But why would a government ever print or produce far more money than its economy is worth? Well, they may try to stimulate their economy by dumping more access to money and loans on banks to get things moving temporarily, as in the case of quantitative easing. Or they may have large amounts of foreign debt owed in their own currency and they want a shortcut to pay it off quicker (as was the case with the hyperinflation seen in Weimar Germany in the 1920's).
Supply and Demand
Inflation is also associated with the supply and demand for goods and commodities. When not enough of a needed good is being supplied, people will want to or need to pay more to get it (and vendors will price things accordingly).
Hurricane Katrina offers a classic example. In the supply disruption and infrastructural damage that followed, the price of bottled water increased dramatically. Why? Because clean water is necessary to stay alive and people were willing to pay more to get it. Now imagine simultaneous crises causing supply shocks for different essential commodities (food, fuel, energy) and you can see how overall prices can quickly increase.
Demand also has its part to play. Steady or growing demand for goods is normally seen as a good thing as stable demand increases revenue, pushing economic growth. But what if demand outstrips supply and production can’t keep up with people’s need for resources? Then prices increase from the need to preserve what little there is to go round.
Governments and economic authorities are in a precarious balancing act: trying to encourage demand and growth but only at a rate where an economy can keep up with the needs of the people. If elected officials and civil servants make poor decisions, the results cascade down and can be catastrophic for ordinary citizens.
Psychology and anxiety
Based on what we’ve just read, we can also see how people’s psychological reaction to things they think will increase inflation can actually drive inflation too.
As humans, we tend to look for trends: if we see prices increasing over a period of time, we expect that they will continue to increase. Fear of higher prices in the future means that suppliers demand higher prices for their goods out of anxiety and about potential weakening of a currency’s purchasing power.
This also happens in contracts and negotiations around regular payments (wages, goods and services, rent, etc.) When these contracts come into force, the anxiety about inflation becomes a self-fulfilling prophecy. Without some kind of mechanism to guarantee fairer pricing and negotiated terms, this can spiral into an inflationary cycle. It’s a vicious cycle: recent increases in prices create a trend where people expect further increases so they raise their prices to cover the costs.
How do we measure inflation?
Inflation is easy to experience, you’ll have obviously felt the pinch recently as prices increase. However, it can be harder to calculate exactly because different measures have different purposes. None of them perfectly reflect an accurate picture of how price increases affect everyone, including society’s poorest.
The U.S. Bureau of Labor Statistics’ Consumer Price Index (CPI), for example, looks at the pricing for a selection of typical foodstuffs and consumables, charting the general percentage change over time. The CPI compares year-on-year changes based on the overall percentage change in all of these goods. The goods in this “basket” are generally the same every year, but can change to include new technology and remove obsolete or old items.
However, this isn’t always a good indicator of increases to the cost of living. Poorer people clearly have to spend a larger percentage of their income on food, fuel, and utilities so increases in prices for these goods will disproportionately affect them. Put simply, people with lower incomes experience greater inflationary pressure than people with larger incomes.
Then there are value product lines where supermarkets produce and sell generic or store-brand items at the lowest prices for marginal profits. In an economic crisis, many of these lines may be discontinued only to increase in price when (or if) they return. Items in the “basket” used to calculate inflation just vanish from the shelves. Simply put, even small inflation increases are felt much more painfully the lower you and your family are down the economic ladder.
Small promotions and increases in income won’t offset the decrease in purchasing power. This means that your income needs to constantly increase through wages or investment at a pace that matches or even exceeds the yearly rate of inflation just to maintain the same quality of life.
The Consequences of Inflation
Economists these days advise low, predictable rates of inflation as being good for a country’s economy. This stability makes contracting for goods, services, and property less likely to see large changes in terms of costs from one year or one shipment to the next. Prices gradually increasing is considered a good thing by governments and banking authorities because it means consumers are pushed to buy things sooner and boost the economy. This means that central bankers and policymakers are trying to make inflation seem like an acceptable part of everyday life for governments and consumers alike, welcoming stable increases to the CPI as good for everyone.
However, higher and higher rates of inflation are becoming accepted as more and more common with every passing year. There is a danger to normalising increasingly large jumps in prices as “the price of doing business”. People will reject poor monetary policy decisions that feed runaway inflation. Even worse, when inflation becomes hyperinflation, this creates a crisis point where fiat money becomes so degraded that it’s essentially worthless. We’ve already mentioned Weimar Germany in the early 1920’s but for an example closer to our era, we can look to Zimbabwe in 2008.
Decades of poor financial and social policies, along with a brutal dictatorial regime, meant that a country that had been one of Africa’s rising stars (with good population growth and a 5% economic growth rate in 1980) reached an annual inflation rate of 500 billion per cent in 2008, with prices doubling every 24 hours.
This eventually meant Zimbabwe had to surrender its currency altogether, but not before people returned to older traditions of exchanging value: barter, shadow economies (using other items to stand in for money, or simply switching to a foreign currency like the U.S. dollar or the South African rand), and exchanging precious metals and other valuable items.
The Zimbabwean monetary system may never recover as, after decades of misrule, people are wary about any fiat currency issued by the country. This reluctance isn’t exclusive to Zimbabwe, though. Look at how many adverts and services sell precious metals or other resources to help people feel more secure in increasingly unstable economic conditions (like the recent COVID-19 pandemic). This happens even in the face of evidence that metals like gold are haven’t served as well as they could have in terms of inflation-proofing in the past.
In Part 2, we’re going to discuss what things you can do to try and hedge your income against inflation, as well as exploring passive and active income in the future as a means of defending your idle assets from “the silent thief”. We’ll also discuss the ways many crypto currencies, like Bitcoin, are considered “inflation-less” by nature and have the potential to combat the effect of price increases by helping savers keep more of their money for longer.