Inflation Coming? Possibly.
What it is and what that means
What Is Inflation?
Inflation measures the rate at which the average price level of a basket of selected goods and services in an economy changes over time. If positive, it is the rise in the general level of prices where a unit of currency effectively buys less than it did in prior periods. Often expressed as a percentage, inflation reflects a decrease in the purchasing power of a nation’s currency.
Main Points
- Inflation is the rate at which prices for goods and services rises and, consequently, the rate at which the purchasing power of currency falls.
- 3 Types of Inflation: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
- Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
- Inflation can be positive or negative, contingent on the individual viewpoint and rate of change.
- Inflation favors those with tangible assets, like property or stocked commodities, as it raises the value of their assets.
- People holding cash may not like inflation, as it erodes the value of their cash holdings.
- There is an optimum level of inflation, which is required to promote spending to a certain extent instead of saving, thereby nurturing economic growth.
Inflation can be contrasted with deflation, which occurs when prices decline.
Decreased Purchasing Power
As prices rise, a single unit of currency loses value as it buys less. This loss of purchasing power impacts the general cost of living for the common public which ultimately leads to a slowdown in economic growth. The consensus view among economists is that sustained inflation occurs when a nation’s money supply growth outpaces economic growth.
To remedy the dangers of this, a country’s central bank (in America, the Federal Reserve) then takes the necessary measures to keep inflation within permissible limits and keep the economy running smoothly.
Causes of Inflation
Rising prices are the root of inflation, though this can be attributed to different factors. In the context of causes,inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
The Formula for Inflation
The above-mentioned variants of inflation indexes can be used to calculate the value of inflation between two particular months (or years). There are inflation calculators on various financial portal and websites, but the underlying methodology is based on this formula:
Change in Inflation = (Final CPI Index Value/Initial CPI Value)
Application to Wealth Building
Inflation promotes investments, by businesses into projects and by individuals into publicly traded stocks, as they expect better returns than inflation. An optimum level of inflation is also required to promote spending to a certain extent. If the purchasing power of money remains the same over the years, there may be no difference in saving and spending. It may limit spending, which may negatively impact the overall economy as decreased money circulation will slow the economy down.
High, negative, or uncertain value of inflation can negatively impact an economy. It often leads to uncertainties in the market, prevents businesses from making big investment decisions, leads to unemployment, promotes hoarding as people flock to stock necessary goods at the earliest amid fears of price rise and the practice leads to more price increase, may result in imbalance in international trade as prices remain uncertain, and also impacts foreign exchange rates.
Controlling Inflation
A country’s financial regulator shoulders the important responsibility of keeping inflation in check. The Federal Reserve, in the United States, has long-term inflation goals in order to keep a steady long-term rate of inflation, which in turn, maintains price stability.
Price stability — or a relatively constant level of inflation — allows businesses to plan for the future since they know what to expect. It also allows the Fed to promote maximum employment, which is determined by non-monetary factors that fluctuate over time and are therefore subject to change. For this reason, the Fed doesn’t set a specific goal for maximum employment, and it is largely determined by members’ assessments. Maximum employment does not mean zero unemployment, as at any given time there is a certain level of volatility as people vacate and start new jobs.
Monetary authorities also take exceptional measures in extreme conditions of the economy. For instance, following the 2008 financial crisis, the U.S. Fed has kept the interest rates near zero and pursued a bond-buying program — now discontinued — called quantitative easing. Some critics of the program alleged it would cause a spike in inflation in the U.S. dollar, but inflation peaked in 2007 and declined steadily over the next eight years. There are many complex reasons why QE didn’t lead to inflation or hyperinflation, though the simplest explanation is that the recession itself was a very prominent deflationary environment, and quantitative easing supported its effects.
If inflation is a threat to the economy again, the Fed will likely respond accordingly.
Hedging Against Inflation
Stocks are considered to be the best hedge against inflation, as the rise in stock prices are inclusive of the effects of inflation. Since any increase in the cost of operation leads to an increase in the price of the finished product a company produces, the inflationary effect is reflected in stock prices.
Additionally, special financial instruments exist which one can use to safeguard investments against inflation. They include Treasury Inflation Protected Securities (TIPS), low-risk treasury security that is indexed to inflation where the principal amount invested is increased by the percentage of inflation. One can also opt for a TIPS mutual fund or TIPS-based exchange traded fund (ETFs). To get access to stocks, ETFs and other funds that can help to avoid the dangers of inflation, you’ll likely need a brokerage account.
Real Estate & Gold are also considered to hedge against inflation, although this doesn’t always appear to be the case.
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