I don´t know how you feel, for me, inflation is something very worrisome- so I do worry a bit at the moment. For quite some time now, we have had a daily dose of ” threat of inflation” and why we need to be careful, and why central banks and governments alike need to do something, presto preferably, to rescue us.
Fact is, global economies are experiencing the worst inflation since the 1990ies. Stock markets are a bit nervous and react with volatility. Unemployment rates remain high. Little makes sense at the moment and this worries us. Let´s put the spotlight on the issue, without going too much down the rabbit hole.
So let´s shine some light on
- What actually happens during inflation?
- The very brief history
- The 2021, and beyond inflation
- The Pandemic & Government Help
- Cheap Money
- Climate Change
- Real Estate
- Workforce-Minimal Wage Policy
- Chip shortage
- Is there a healthy inflation
- Now what?
What actually happens during inflation?
Inflation is the reduction of purchasing power of a currency offer at a given time- usually, prices for goods are compared over a period of one year. A unit of currency buys fewer goods, utilities, and services than the year before, to avoid mistakes the basket of selected goods and services remains the same. The common measure of inflation is the INFLATION RATE and the annual percentage change in the CONSUMER PRICE INDEX. The opposite of inflation is deflation, a sustained decrease in the general price of goods and services- sounds nice but is in fact very bad.
Very high inflation and HYPERINFLATION are a worst-case scenario for any economy. As a currency loses value, prices rise and it buys fewer goods and services. This loss of purchasing power impacts the general cost of living for the common public which ultimately leads to a deceleration in economic growth. The consensus view among economists is that sustained inflation occurs when a nation’s money supply growth outpaces economic growth, this is commonly known as MONETARISM. Economists however are less unified in their opinion on how to curb high inflation.
High inflation or fluctuating inflation puts major costs on economies. Businesses, employers, consumers feel the effects of generally rising prices and add an additional source of uncertainty to decision making. The adjusting economic behaviour leads to a general rise in prices without real economic fundamentals- this adds further to the cost of the economy
The Three Causes of Inflation
Demand-Pull Effect
The increase of money supply and cheap credit stimulates the overall demand for goods and services increases more rapidly than the economy´s production capacity. The increase in demand leads to prices rising.
Cost-Push Effect
When the additional supply of money or credit is channeled into a commodity or to other asset markets ( real estate, stocks, gold) accompanied by a negative economic shock to the supply of commodities costs for all kinds of intermediate commodities rise as well.
Wage-Spiral Effect
People expect the current inflation rate to continue into the distant future, prices of goods and services continue to rise at a given percentage, so members of the workforce expect their salaries to rise at the same pace to maintain their standard of living. The increase of wage results in an increase in prices for goods and services, this is a spiral where one factor induces the other.
Inflation is viewed positively or negatively depending on the individual viewpoint. It is commonly accepted, that those with tangible assets, like real-estate, stocked commodities, or owners of gold, may like to see inflation as that raises the value of their assets. Buyers however of assets and commodities are less happy. People holding currency-based assets, like bonds or cash are also not really happy as the value of their holdings is eroded over time if inflation persists.
A very brief history
Large infusions of gold or silver into markets led to inflation. While silver was a currency, governments would collect silver coins melt them downmix them with other metals and reissue them at the same value. For example, around CE 60 the Roman Denarius contained 90% silver by CE270 the coins contained hardly any silver-the amount of coins could be increased without using more silver so the relative value of each coin was devalued and more coins were needed to buy individual goods or services.
The introduction of FIAT currency – money is handed out and its value determined by governments – opened the door to much larger variants of the money supply. A country´s political crisis often went along with a sharp increase in money supply producing hyperinflation.
The Yuan Dynasty ( CE 1271-1381) spend large sums on fighting wars, the printing press was put in action to finance the wars and created massive inflation- the dynasty did not survive. The economy failed, famine was widespread and the population was disgruntled
On his pilgrimage to Mekka, passing through Egypt, the Malian King, Mansa Musa, distributed huge amounts of gold amongst Cairo´s population, the price of gold in Egypt remained depressed for decades.
From the 15th Century to the 17th century Western Europe went through major inflationary periods. One reason was the growth in population after the plague which had caused serious depopulation. More people demanded more products, prices rose as manufacturing could not keep up with demand.
The discovery of silver and gold in the latter half of the 16th century, by the Spaniards in the New World, and its distribution to cash-starved Europe led to inflation
In the 1920`s Germany went through Hyperinflation. Reparation demands negotiated in Versailles, by the victorious WWI countries could not be met by Germany without going into major debt. Excessive government borrowing mainly from American Banks led to Germany printing paper money to buy more currency to pay the debts, a never-ending spiral. The German Mark was rapidly devalued which led to Hyperinflation. Germans had to spend their money the moment they received it as more and more money flooded the market. Paper money had become so worthless that people papered the walls with it.
The 2021, and beyond inflation
Pandemic-government help
The Covid-19 pandemic resulted in lockdowns in most economies around the world. Governments initiated substantial aid programs to protect the population from undue financial hardship caused by a lockdown forced upon them.
Governments spend huge amounts of money to give financial support to people who were hit hard by lockdowns. Workplaces and companies alike were rescued and supported.
Many central banks and governments decided generous post- pandemics aid packages worth trillions. The US spending back dwarfs the EU or any other country’s package by far. Interest rates will be kept at an all-time low, some even negative.
As a result, stock markets are at an all-time high, after a severe slump at the beginning of the pandemic. Not really a surprise as there is a lot of money floating around desperately looking for opportunities, whatever the cost.
As soon as vaccines had reached the peoples’ arms, and lockdown restrictions eased consumers were out and about again, to catch up on missed spending opportunities. But now demand outstrips supply and prices go up, remember production and shipping came to a halt due to lockdowns.
So here we are the Demand-Pull Effect. However, this should be a short-lived phenomenon as production and shipping will go back to normal, as excessive demand, and the currently high inflation rates of up to 5% + should go down. So a rather temporary effect which is nothing to worry about.
All the cheap money
A relaxed monetary policy is a cause for large amounts of money in circulation. But this is not due to the pandemic alone, in fact, since the financial crisis in 2007-2008, central banks have been supplying markets with vast amounts of money. Fact is, since 2008 cheap money is being flooded into markets, interest rates are at an all-time low, and the number of billionaires and millionaires rise in inflationary proportion. The pandemic government spending spree adds only adds to the problem.
All this cheap money causes all-time highs at stock markets around the globe. Is desperate money looking for opportunities at all costs? It is questionable if share prices still reflect the true value of a company, stocks of companies with weak earnings are traded at high prices, it seems investors are so desperate to park their cash just anywhere and throw their money at anything.
Low-interest rates are certainly good for government and company debts, borrowing is cheap and the book value of debt is reduced at a steady pace, without further effort or cost.
A Cost-Push Effect and economists, politicians, and central bankers have diverging opinions on how to curb the problem. Raising interest rates is one option and would stop further “gambling” at the stock market. An added plus would be the elimination of zombie companies who ceased their purpose of contributing to any kind of economic growth but suck the system. Cheap money is something investors and policymakers should pay more attention to, this could become more worrisome than we all like to happen.
Climate change drives consumer prices
Nobody in their right mind will debate the fact that we do have a climate problem and we need to combat the impact it has. After a lot of pressure, governments are busily setting up ambitious government programs to save the climate. However, with side effects. Not only energy prices but the cost of almost everything we need to enjoy the comforts of modern-day life will go up.
CO2 tariffs, the price for mobility, rising costs for insurance due to weather extremes, extra costs for energy-efficient buildings will the price for living, the need for more electricity will drive electricity prices, production costs and the price for services will continue to go up for everyone and for everything we use on a daily basis.
Real Estate – skyrocketing prices
During lockdown house prices literally went into a deep freeze. Some feared that 2008, the subprime crisis, would repeat itself. The result is known, plenty of cheap money flooded the markets, central banks started an unparalleled bond-buying spree, and banks and economies were saved from total collapse. A growing fear that house prices would collapse again and add additional pressure on economies at a complete standstill, something a lot would expect during an economic downturn.
But none of this happened this time, instead, house prices went on an upward trajectory. As the OECD found out that between Q4 2019 and Q4 2020 house prices grew at the fastest pace in 20 years.
Low-interest rates took the pressure of borrowing and repayments, in some countries plenty of government cash was added to private coffers, and others reduced purchase taxes and thus spurred home buying.
Homes had to be transformed into offices and classrooms and many re-assessed what they want from a home. Many executives changed their expensive townhouses for bigger and cheaper houses in the country. Being locked up in the country seemed preferable to being locked up in a big city. Some even had more money available as less was spend on traveling, restaurants, and clothes, and house prices turbocharged.
The panic buying frenzy is also sparked because many buyers believe the economy is tanking, owning real estate is considered to be a safe haven against inflation. Many governments started to introduce measures to clamp down to prevent markets from overheating and to avoid risky speculation.
Workforce & minimal wage policies
Most economies are still grappling with fairly high unemployment rates, but this is a post-pandemic effect and should ease as soon as economies around the globe are back to the pre-pandemic level. At the same time, some industries face the problem to fill vacancies.
Longterm we will see the reduction of the workforce for demographic reasons. especially developed economies face a significant fall in birth rates a shortage in the available workforce will be a major driver of inflation. A reduced workforce will lead to an increase in salaries, the shortage will allow employees to ask for higher salaries to fill vacancies. These higher costs will be passed on to the consumer by raising product or service prices.
The minimum wage policy governments in many economies pursue, will be reflected in an increase in product prices and services and will be a contributor to higher inflation.
This Demand-Pull Effect is mainly a problem of developed economies and will give politicians, unions, and employers plenty to chew on.
The chip shortage
The chip shortage is another, yet temporary cause for inflation. For years now, western economies rely too much on chips being manufactured in Asia, now due to lockdowns in Asia we face a worldwide chip shortage as global production is slowly going back to normal.
The shortage causes manufacturers in many economies to shut down, the car industry is especially badly hit. Products where chips are involved, and there are many from cellphones to door opening systems see a steep rise in prices as demand exceeds supply.
The Demand-Pull Effect will be eliminated by production in Asia gaining traction again but manufacturers should be rethinking outsourcing policies and dependencies. Thinking about producing local would not be a bad idea, to guaranty a smooth supply of chips in the future, certainly less expensive than having to shut down manufacturing. this includes the higher production costs in western economies.
Speed read
Inflation is the reduction of purchasing power of a currency at a given time, usually over a year.
High inflation or fluctuating inflation puts major costs on economies.
The three causes for inflation: Demand-Pull Effect; Cost-Push Effect; Wage-Spiral Effect
Main driver of the 2021 rise in the inflation rate is extensive government help during the Covid 19 pandemic
Combating climate change results in a rise in consumer prices for a long time to come.
Increased demand for real estate heats up prices.
Due to a shrinking workforce, labor becomes more expensive
Minimum-wage policies drive labor cost resulting in higher consumer prices
Many economists favor a low and steady rate of inflation, the target inflation rate is about 2% to 3%.
Central Banks exist to maintain a stable and growing economy through price stability and full employment central banks do this by manipulating short-term interest rates, engaging in open market operations (OMO), and adjusting reserve requirements
Succesful wealth owners protect their wealth by staying level headed, thinking long-term when it comes to investment decisions, and by keeping cash to a minimum
Healthy Inflation
A country’s central bank shoulders the important responsibility of keeping inflation in check. It is done by implementing measures through monetary policy, that determine the size and rate of growth of the money supply.
Most economists today favor a low and steady rate of inflation. In most countries, central banks or other monetary authorities are tasked with keeping their interbank lending rates at low stable levels, and the target inflation rate of about 2% to 3%. The theory states a zero or negative inflation rate has a worsening effect on recession, low inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly.
Price stability—or a relatively low level of inflation—allows businesses to plan for the future since they know what to expect, this will promote maximum employment.
inflation can prevent deflation. An economy where consumers wait for prices to drop can stall, which leads to less production and results in high unemployment.
Inflation encourages borrowing and lending, repayment is made easier for investors is made with money less valuable than the amount borrowed. So spending overall is encouraged and
There are many theories why some inflation is healthy for economies. Preventing deflation is one, a steady rise in prices will prevent consumers from postponing purchases because they hope for lower prices another, another theory sees inflation as a nuisance because saving is made harder and people are driven into riskier investment strategies. Yet another theory claims that high inflation rates can prevent unemployment- this theory however was discredited in the 1970ies when high inflation rates in the US had led to stagflation.
Now what?
Like always with finances, we should stay level-headed, look at the bigger picture and think long-term. Maybe interest rate does go up and the stock market down, but gambling is a very unsuitable method for long-term financial security, so a hasty selling of assets is not the right thing to do despite the high volatility.
Media and well-meaning “experts” have a tendency to predict some sort of threat to wealth at very regular intervals. An attractive and rewarding business, with a guaranty to attract maximum attention, after all, it concerns so many. They can never go really wrong or have their reputation tarnished as they always manage to come up with explanations why the predicted inflation did not happen and why the event has to be postponed into the future.
Many economists and self-declared experts have been predicting a “roaring” inflation of 5% for the past 10 years, yet we have not seen it yet, nor is hyperinflation round the corner.
“Monetary policy” has measures in place to stop inflation from rising to a level that would endanger not only the economy at large but wipe out individual wealth
Raising interest rates
Higher interest rates reduce the economy’s money supply, fewer people would seek loans. When banks give loans, the loan proceeds are generally deposited in bank accounts that are thus part of the money supply. Therefore, when a person pays back a loan and no other loans are made to replace it, there is no bank account need to hold the money and the money supply decreases
Fixed exchange rates
Under a fixed exchange rate currency regime, a country’s currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it.
Wage and price controls
In general, wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.
Bond purchasing programs
Central banks in developed economies embarked on massive bond purchasing programs since the subprime crisis in 2008. With the first lockdown measures during Covid 19 pandemic. Many central banks accelerated their bond-buying program and pushed huge amounts of cash into the markets by buying up debt. Slowing down the program is similar to raising interest rates it curbs inflation as no further cash is pumped into markets.
Reserve Requirements
Central banks have the ability to adjust banks’ reserve requirements, which determines the level of reserves a bank must hold in comparison to specified deposit liabilities. Based on the required reserve ratio, the bank must hold a percentage of the specified deposits with the central banks.
Personal wealth protection
The golden rule to protect wealth long-term is having real estate investments (not the place you live in), some gold, and investments in other assets or commodities at an equal level., depending on the market situation. Cash in a bank account is not a good idea. Keeping cash is with or without inflation, not a very smart thing to do. Investments made with large amounts of “cheap” borrowed money might turn sour as well. Because as soon as interest rates go up and the leverage advantage will have vanished in the worst case the investment made goes bust and the money owed to the bank exceeds the total investment.
