Inflation refers to an extended rise in the cost of items and services during a period. To some, it means a falling economy, while others see it as a good thing. First, we’ll look at some of the long-term consequences of inflation. In our next post, we’ll dive into how to profit from inflation.
KEY TAKEAWAYS: INFLATION
- Over time, price increases for items and services has both advantages and drawbacks.
- Inflation reduces purchasing power.
- Inflation reduces the value of cash, so consumers spend and stockpile goods.
Eroded purchasing power
The first effect of inflation is lower purchasing power. For example, a cup of coffee used to cost a dime, and it’s now more than three dollars.
A hike in the price of coffee, a cartel of coffee producers’ price pooling, years of devastating drought, flooding, or conflict in a critical coffee-growing region might all have caused the price increase. In cases like these, coffee products would cost more, but the rest of the economy would go on undisturbed. That wouldn’t qualify as inflation because only those who drink a lot of coffee would see significant losses in their purchasing power.
Inflation occurs when prices rise across a “basket” of goods and services, such as the consumer price index (CPI). As the costs of non-discretionary items that cannot be substituted—such as food and gasoline—rise, they may impact all by themselves. As a result, economists frequently isolate food and fuel to examine “core” inflation, a lesser volatile way to calculate price increases.
Increased spending and investing
When purchasing power decreases, people buy now rather than later. But unfortunately, cash will only lose value, so it’s best to get your shopping out of the way and stock up on things that are unlikely to decrease price.
Consumers spend money on things like gas, food, and clothes. For businesses, it implies making significant investments that might otherwise be put off until later. When inflation rises, many individuals invest in precious metals such as gold and other valuables. Although these items provide some level of protection from price increases, the volatility of these assets can outweigh this benefit in the short term.
Equities have historically been one of the best inflation hedges. For example, on Dec. 12, 1980, one share of Apple Inc. (AAPL) traded at $29 in current, not inflation-adjusted, dollars. When adjusted for stock splits and dividends, that one share would be worth $7,035.01 at close on Feb. 13, 2018. The Bureau of Labor Statistics CPI calculator states $2,438.33 in 1980 dollars, implying an 8,346% gain.
For example, let’s say you had put that $29 in the backyard instead. The nominal value wouldn’t have changed if you dug it up, but your purchasing power would have dropped to about $10.10; that’s a 65% decline. Of course, not every stock would have done as well as Apple: burying your money in 1980 was preferable to investing in Houston Natural Gas, which subsequently merged to form Enron.
Ultimately, the urge to spend and invest in the face of rising prices generally leads to higher inflation, creating a potentially deadly feedback loop. The economy is flush with cash no one particularly wants as people and firms spend faster to slow the rate at which their money loses value. As a result, as currency supply exceeds demand, money’s purchasing power decreases exponentially.
When things get terrible, an excellent impulse to keep business and house items on hand rather than keeping cash in the bank deteriorates into hoarding, resulting in empty grocery store shelves. People become desperate to unload money so that every payday becomes a mad rush to spend as much as possible on anything other than ever-more-worthless currency.
Hyperinflation is the result. Hyperinflation led to Germans papering walls with worthless marks in the 1920s. Peruvian cafes raised prices many times per day in the 1980s. Zimbabwean consumers were hauling wheelbarrows of million- and billion-Zim dollar notes in the 2000s. Venezuelan thieves refused even to steal bolívares in the 2010s.
Increased borrowing costs
States have a strong incentive to keep prices under control, as these examples of hyperinflation demonstrate. For the past century, the United States has used monetary policy to combat inflation.
The Federal Reserve (the United States’ central bank) relies on the link between inflation and interest rates. If interest rates are low, entrepreneurs and individuals may borrow cheaply to start a business, get an education, recruit new employees, or purchase a beautiful boat. In other words, when rates are low, people spend and invest money readily, which is generally followed by higher prices.
Central banks can dampen these rampaging animal spirits by raising interest rates. Fast forward a few years, and the payments on a boat or corporate bond issue may appear high. It’s probably better to keep some of your money in the bank where it can earn interest. When there is less cash floating around, money is more difficult to come by.
Scarcity is what adds value to money, although central banks don’t want it to become more valuable as a rule. They are afraid of deflation, just as hyperinflation. Hence, they pull on interest rates to keep inflation stable near a target rate (typically 2% in developed countries and 3% to 4% in developing ones).
Another perspective on central banks’ inflation control is through the money supply. If the money supply grows faster than economic growth, it will be valueless, and inflation will occur. For example, in Weimar Germany during World War I, reparations payments and when Aztec and Inca coins flooded 16th century Spain in the 16th.
When central banks decide to raise rates, they typically can’t do so by fiat. Instead, they sell government securities and take the proceeds from the money supply. As the money supply falls, so does the inflation rate.
Lowered borrowing cost
When there’s no central bank, or when central bankers are under the control of elected officials, borrowing costs will generally fall.
Assume you borrow $1,000 at a 5% yearly interest rate. If inflation is 10%, your real debt is getting smaller than the total interest and principal you’re paying off. When household debts soar, politicians seek to stoke inflation to gain political advantages by printing money and relieving citizens’ obligations (once again, Weimar Germany is the most notorious example of this result).
Several nations believe that independent central banks should carry out fiscal and monetary policymaking following the politicians’ periodic infatuation with inflation. However, while the law requires the Fed to pursue a high employment rate and stable prices, it does not require presidential or congressional approval to make its rate choices.
That is not to say that the Fed has had a free hand in policymaking. Narayana Kocherlakota, former president of the Minneapolis Fed, wrote in 2016 that although the Fed’s independence is a post-1979 development based mainly on the president’s restraint,
There’s some evidence that inflation lowers unemployment. Wages are usually sticky, implying they take a long time to adjust to economic changes. John Maynard Keynes believed wage stickiness partly caused this period. Because employees opposed pay cuts and were laid off rather than being given a smaller wage (the ultimate pay cut), unemployment increased.
The same forces may also reverse, with high wages keeping employees from leaving and declining to move.
That hypothesis explains the inverse correlation between inflation and unemployment, but a more common explanation points to unemployment. According to this view, as unemployment drops, businesses are compelled to pay more for people who have the talents they require. As wages rise, so does consumers’ purchasing power, which stimulates economic growth and raises prices using cost-push inflation.
In the short term, a high rate of inflation has several drawbacks. First, it discourages people from saving because deposits lose their purchasing power over time. That prospect encourages consumers and businesses to spend or invest. At least in the near term, the increase in spending and investment results in economic growth. Inflation’s antagonistic relationship with unemployment also implies a push to employ more individuals, which leads to development.
This is most apparent in its absence. Central banks throughout the developed world struggled mightily to raise inflation and growth in 2016, owing to a lack of success. Rates were reduced to zero and below, but this did not work. Neither did buy trillions of dollars worth of bonds purchased during a money-creation program known as quantitative easing.
In this scenario, moderate inflation was seen as a positive growth stimulant, and investors welcomed the rise in inflation expectations due to the election of Donald Trump. However, markets incurred substantial losses in February 2018 due to concerns that rising prices would prompt an accelerated rate increase.
Reduced employment, growth
Discussion about the advantages of inflation is bound to seem unusual to those who remember the 1970s’ economic troubles. You have stagflation when growth is slow, unemployment is high, and inflation is double digits. A British Tory MP coined the term in 1965 during sluggish growth, high unemployment, and double-digit inflation.
The term “stagflation” was initially used by Keynesians to describe a period of severe economic sluggishness that afflicted the United States during the 1970s. Keynesians refused to believe it could occur early on since it contradicted the Phillips curve’s inverse relationship between unemployment and inflation. However, after they accepted its existence, they attributed the most acute stage to the supply shock provoked by the 1973 oil embargo: as transportation costs rose dramatically, GDP ground to a halt, according to some theories. In other words, it was cost-push inflation at work.
During the 1970s, a five-quarter run of productivity reduction followed by healthy growth in the fourth quarter of 1974 supports this notion. However, in the third quarter of 1973, output fell before Arab OPEC members closed the valves in October.
Supply-side economists blamed high taxes, regulation, and a welfare state for the trouble. Policies combined with monetarist-inspired tightening by the Fed ended stagflation.
Inflation is usually linked to a declining exchange rate, although this is typically the result of a weaker currency causing inflation rather than the other way around. This is because when currencies fall against those of their trading partners, importing economies must pay more for these imports in local-currency terms since their currencies have fallen against theirs.
For example, if Country X’s currency falls 10% against Country Y’s, the latter doesn’t have to raise export prices to Country X for them to cost 10% more. Indeed, the weaker exchange rate alone has the same effect.
However, when considering the long-term trend, it is easy to see that inflation can do one thing or the polar opposite in some situations. Therefore, it appears entirely reasonable that higher prices would result in a weaker currency when you remove most of the world’s moving components.