The Oxford dictionary defines inflation as “a general increase in prices and fall in the purchasing value of money.”
Yes, you read that right, it says that the money you hold is becoming WORTH-less due to inflation. Inflation is the invisible evil that leads to prices of things “rising” and the value being provided staying the same. Remember when in 1990, the price of a gallon of gas was less than $1 (nearing $5 in CA now), and a loaf of bread cost $0.75 (over $3 now!).
In case you were wondering what has led to the prices of these products rising, and making your dollars WORTH-less over time - it’s INFLATION.
How does it get “created”?
Economists generally agree that inflation is caused by two primary factors
Supply Side effects - This happens when
- The prices of raw materials (iron, copper, oil, gas, fertilizers etc..) go up, due to shortages of some kind. These might be due to manufacturing issues, the weather or other such issues.
- Wages rise, generally due to labor shortages
In this scenario, demand for goods and services stays constant but the supply side constraints lead to higher prices which are then passed onto the consumer.
Demand side effects - This happens when
- There is a sustained high demand for goods and services from consumers. Supply is not able to keep up, and hence prices rise!
In this scenario, prices rise because consumers are willing and able to pay more. This historically has occurred in times of economic expansions and growth.
However, in the recent past in the USA, we have seen inflation solely due to the monetary policy actions of the U.S. Federal Reserve. They have flooded the system with “cash” there by making the existing cash be WORTH-less than it was before, leading to an increase in prices.
How does or will inflation affect you?
Inflation will make the price of most things rise, especially things that are essential and non-substitutable. Think gas for your car, or for heating your home in the winter.
Inflation also leads to an increase in housing costs, whether it’s rent or the purchase of a home. This happens because of the raw costs associated with housing (commodities & labor), and the fact that we all need to live somewhere!
Basically, inflation makes things more expensive!
When was the last time we had real inflation in the US?
The last major period of inflation in the US was the 70s and early 80s, with Fed Funds interest rates rising to 20%! Yes, you read that right 20%!
For context, inflation in 1964 and the preceding 6 years was at ~1%.
History tells us that there were a variety of reasons for this:
- The end of the gold standard and the collapse of the Bretton Woods system.
- Massive energy shortages (Oil & Gas)
- Arab oil embargo of 1973, that led to a 4x in the price of oil
- Iranian revolution in 1979, that led to a further 3x increase in oil prices
- Mandate of Full Employment for the Federal Reserve with no checks and balances on the management of US Dollar Reserves
Those years were difficult and with a lot of economic slowdowns and recessions, until inflation was brought under control in the late 80s. It took over 10 years to tame the beast! For those of you interested in more details on this, check out this essay by Michael Bryan from the Federal Reserve of Atlanta
What can you do to prepare for inflation or combat it?
Inflation is a tough nut to crack. It’s really quite hard to beat it without taking “risk”. This would mean investing money in stocks, real estate, gold, oil or “high yield” bonds.
For those of you that are more safety minded, the options would be limited to US Government Bonds & Investment Grade Corporate Bonds. These will help you reduce the drag on your capital caused by inflation. We go into the details of leveraging this option in our blog post here