It was a cold long night on the streets. The buildings were all covered with a dark mushy fog. The air smelt of toxicity and crime. I could already know that something bad happened. Walking down the road, I found a 24h shop that sells newspapers. I bought the latest number of my favorite gazette. It was 1.07$….I remember, that on the same day, last year it was just 1$. How time flies.
Everything is gloomy and cold…then my phone rang. I already know what was about, from the first moment I saw the number. The precinct was calling me again. Someone was killing the Economy Fund again. But this time, we already had a suspect and we called it …INFLATION.
What is Inflation
According to Investopedia.com, Inflation is the decline of the purchasing power of a given currency over time. We can observe the inflation at its best, in the increase of an average price level for a selected basket of goods. For example, last year the newspaper was 1$ but today, it is 1.07$.
To rephrase what I just said, when the general level of the prices rises, we can buy less, so our currency is worth less than it was before. Overall, a high inflation rate has a bad influence on the quality of life for the population, thus leading to a deceleration of economic growth.
The ECB (European Central Bank) has a good example of how inflation is reflected inside the consumer basket.
Now that we understand that, in fact, inflation is bad for your money, because over time they are losing the power to buy things, most economists consider that small inflation is beneficial for each type of economy because it stimulates growth. Based on this assumption, in 2012, the Federal Open Market Committee USA decided at a target of 2% annual inflation.
Causes of Inflation
Considering the supply and demand chain, we can have inflation due to a shortage of supply, leading the price of the existing products to newer highs. The same thing can be applied to money. If there is more money on the market, then the product prices tend to rise.
Money supply can be increased by the monetary authorities either by printing and giving away more money to individuals (like the bonus/stimulus accorded to USA citizens), legally devaluing the local currency, or by loaning money as a reserve account by purchasing government bonds from banks on the secondary market (a totally different practice that issuing bonds to the population).
There are three main causes of inflation:
- demand-pull inflation – not enough products/ services on the market (the situation explained above)
- cost-push inflation – the cost of producing products and services is increasing, thus leading to an increase in the final product
- built-in inflation – workers/employees demand higher wages to keep up with the rising living costs thus leading to business increasing their product price
How it’s calculated
Each country has its own way to calculate the inflation rate and there are multiple ways to do it. The USA is calculating inflation by taking into consideration 3 indices:
- The Consumer Price Index – The CPI is an average of the price of a basket of goods (something like the picture from above) and services that are primarily consumed (water, electricity, gas, medical services, etc.). The CPI is calculated by taking the price change and averaging them by the relative weight in the basket.
- Producer Price Index – the PPI measures the modifications that can appear in the selling prices received by domestic producers of intermate goods and services over time. The PPI is measured from the perspective of a seller, opposed to the CPI that is measured from the perspective of a buyer.
- Personal Consumption Expenditures price index – the PCE measures how much the consumers are paying for goods and services, but taking into consideration a broader spectrum of expenses
Of course, there are multiple types of indexes that can be taken into consideration, like the Wholesale Price Index that measures and tracks the changes in the price of goods before the retail level.
An easy formula to calculate the inflation can be Inflation Rate % = (Current year CPI/ Last year CPI) * 100
To be easier to understand how the CPI changes during the years, please take a look on the image bellow, taken from Investopedia.com (as also part of the infos from this article)
What types of inflation we can have
There are four principal types of inflation.
- Creeping Inflation – Creeping or mild inflation is when the prices rise by 2-3% each year. It is what the Federal Reserve decided in 2012. A small increase in prices is beneficial for the economy. This means that consumers will buy this year to beat next year’s inflation, boosting demand.
- Walking Inflation – This type of inflation can be destructive and it is between 3-10%. It is harmful to economic growth because it acts too fast. People will buy more than needed to avoid a future increase in the price, driving the demand higher. Some of the common goods can become too expensive for a larger mass of the population. The wages can’t keep up.
- Galloping Inflation – It is an absolute disaster for an economy. It is represented by a 10% or more increase and money is losing value fast. Most businesses and employees can’t keep up with the costs and prices. Foreign investments disappear from the market as they will try to avoid losses. Also the government losses its creditability (if it’s not lost already).
- Hyperinflation – The prices skyrocket by more than 50% in a month. It is rare and usually avoided. It happens when the government prints money to sustain a war/rebellion/coup-d’etat (see Venezuela problem, Zimbabwe, or even Germany in 1920).
Some other types of inflation can be identified:
- Stagflation – economy growth is stagnant but there are price increases. The USA had this problem when in 1970, they decided to renounce their system backed up by gold (found a nice article here)
- Core Inflation – rising prices in all areas except food and energy. Mainly caused by gas prices escalating every summer
- Deflation – opposite of inflation and for this we will have a separate post on our blog
- Wage Inflation – the wages are rising faster than the cost of living (good for the people but will lead to cost-push inflation)
- Asset Inflation – the bubbles that happen during time: house bubble, .Net bubble, etc.
How are we losing because of inflation
All money that is saved in economic funds, or cash, or in banks with a small interest for the current deposit is affected by inflation. If you have a mutual fund that has a 2% yearly interest, and you are in a 4-5-6% inflation year, you still lose.
A major problem is with credits that have a variable interest, as when inflation raises the variable part of your credit will also rise. This means fewer money will go into the principal part of the credit and more in the interesting part.
Buying new stuff each year is also considered a loss against inflation because they tend to get more expensive each time. With this assumption, the best time to buy is when the inflation is 2% or under 2.
If you have fixed interest bonds are usually affected by inflation, especially if they are in the long term. For example, if you have a bond that reaches maturity in 10years, with an interest of 4% per year, you will have a profit for the years when the inflation is under 4% but actually lose for the period when it is over 4%.
How we can protect against inflation
Some ways to protect and profit from the inflation are the following:
- Real Estate – as the price of the investment will rise because of inflation and in the meantime, you could increase the rent of the tenants
- Investment in Commodities – Gold is traditionally the safeguard against inflation (in long term), having the habit to get more expensive as inflation rises. Other commodities that can be purchased are oil, cotton, soybeans, some other precious metals.
- Bonds – Even if at the previous point I said that we can lose investing in bonds in the long term because inflation can be deadly to any fixed-type income, but there are some Treasury-Inflation Protected Securities available to invest (in the USA) and some other bonds with a high yield can be found.
- Stocks and Stocks indices – as stocks usually are doing well in moderate inflation. If the inflation is too big it can affect some companies in the short term. Investing in indexes that follow multiple stocks (like the S&P500) can be good protection against inflation
- Another way to protect from inflation is to do everything we can to close or transform the variable interest credits into fixed interest credits.
- I do think that P2P investing can be a good way to profit from inflation as more people will search for an alternative way to get some credits, but as it’s not recognized and fully tested I prefer to recommend it only at your own risk
- Consuming less in times of high inflation can help the economy, as the supply will be available and thus the rise in the price will not be affected by the demand-supply chain (demand-pull inflation). Also, you will not pay a 10% increase in the same product you bought last year
Last few words
In 2020, the inflation worldwide rose to approximately 3.4 percent compared to the previous year and according to the IMF, the projection of 2021 is 1 5.9 growth and a 4.9 growth in 2022.
Inflation is considered a silent killer of every investment you have with a yield that is less than the current inflation rate.
Thank you very much for reading the whole article. If you have other suggestions on how to protect and profit from inflation, please leave me a comment.
Disclaimer: I am not a financial consultant! All the information you find here are my decision, I have taken at that moment, on my own analysis. I am open to any type of discussion about money. If you want to replicate my portfolio take into consideration that it is your money and you can have losses.