Inflation Effects
Inflation and Its Effects
Inflation is the measure of the general level of prices for goods and services in an economy over a given period of time.
Inflation’s impact on the economy is vast, varied and can be either positive or negative.Inflation is usually caused by the increase in money supply as well as a change in economic conditions.
Most economic analysts agree that low to steady inflation can be beneficial, while hyperinflation is dangerous.
Inflation rates vary year to year, and currency to currency.
Inflation explains why stamps cost less than 5 cents in the 50’s and are nearly 50 cents now. Rising inflation means that the value of a currency is decreasing or has less purchasing power. Here in the United States, we measure inflation with the Consumer Price Index.
The impact of inflation can be both good and bad for economies. Some of the negative results include the loss of value in real terms, rising prices, less capital investment and the hoarding of goods.
Inflation can also be good in that it can show that a nation is prospering and that its currency is strong, which can encourage investment.
Causes for Inflation
There are generally two causes for inflation: weak economic growth in a country or an excessive increase in the money supply due to accommodative fiscal policy.When you look at the hyperinflation in Brazil or Italy in years past, bad economic conditions coupled with a loose monetary policy are to blame. Things got so bad in those countries that people literally had to bring money in wheelbarrows to buy goods.
When countries experience economic growth, it is usually followed by an equal growth in its currency. As that country’s goods and services become desirable, the demand for their currency grows as well. This demand causes deflationary pressures at home, since their currency is worth more, making goods cost less.
The opposite can happen as well. If a country’s economy is so bad and no one is willing to buy their currency, the value of that currency drops (until it finds buyers). This will make the cost of products soar just to keep pace, therefore causing inflation.
Another more direct way to impact inflation is by simply increasing the amount of money circulated. Sovereign national committees (such as the Federal Open Market Committee here in the U.S.) control the monetary policies for each individual country.
These committees can also control the interest rates in their countries, therefore making their currency strong or weak. Excessive printing of money can lead to hyperinflation, which means prices can skyrocket.
Inflation: An Economic Indicator
Inflation is a measurable way to gauge the health of a country and their economy.Inflation can be good or bad for country, depending where they are in the growth cycle.
When you look at the current situation in the U.S. dollar and commodities prices denominated in dollars, one can see that the decrease in the dollar has led to much higher prices for corn, cotton, coffee, gold, crude oil, wheat, and many other commodities.
How Inflation is Measured
In order to enact the best monetary and fiscal policy for an economy, one must have accurate measures of inflation.
There are varying ways to measure inflation and each has its own value when determining the given inflation of a time or place.In the U.S., the most popular measurement of inflation is the Consumer Price Index and its cousin the Producer Price Index. Other measures of inflation include the Employment Cost Index, International Price Program and the Gross Domestic Product Deflator.
There are many indirect indicators that measure inflation like interest rates and currency indexes, but we will focus on direct measures of inflation.
The Consumer price index
The Consumer Price Index, or CPI is one of the more popular measurements of inflation. The CPI measures the inflation that individual consumers face when they buy certain goods and services. The CPI is calculated monthly by the United States Bureau of Labor Statistics.The CPI uses a market basket of goods and services that most people use on a regular basis. The CPI is used to index wages, salaries and pensions to calculate the real changes in the value of money.
The producer price index
Similar to the CPI, the Producer Price Index (or PPI) is a measurement used by the U.S. Bureau of Labor Statistics to measure inflation over a period of time. Whereas the CPI is used to measure the cost of goods and services an individual consumer pays, the PPI will measure the changes in cost to companies for raw goods.The PPI used to be known as the Wholesale Price Index and can trace its roots al the back to 1890s. Most countries around the world have some sort of PPI to measure the cost of goods and services sold on a base level.
The employment cost index
The Employment Cost Index measures the relative changes in wages, benefits and bonuses for a specific group of occupations.The ECI is a quarterly report from the United States Department of Labor. The index is based off a survey of employers for a variety of occupations in the final month of each quarter. The ECI helps to determine the real cost of labor, and is also considered a leading indicator since wages tend to increase before prices.
The Federal Reserve often cites the ECI as having an impact on their decision making process for interest rates. The index is also used to determine annual U.S. government employee salary adjustments.
Additional Ways to Measure Inflation
Some of the lesser known measurements of inflation are the International Price Program and the Gross Domestic Product Deflator.The International Price Program measures the changes in prices of goods and services for items that are imported or exported. The IPP is measured by the BLS and is done monthly. The numbers come from directly surveying importers and exporters.
The Gross Domestic Product Deflator is a measurement of all new, domestically produced final goods and services in an economy. This is used to find the real GDP for a country or economy.
The GDP Deflator does not use a fixed basket of goods like the PPI and CPI, but rather it is allowed to change to reflect what is actually being bought and sold.
As you can see, they are many different measurements for inflation. Depending on what you are looking for, there’s a measurement to find it.
Inflation Effects on the Markets
Inflation can have a myriad of effects – from some good to many bad.
Inflation can cause hoarding, price distortion, increased risk, lowering of incomes, serious problems for those who are lenders or live on fixed income, increased consumption, lowered national savings, diminishing profits, higher taxes, quickening of business cycles, rising prices of imports and as well as devaluing of a currency.Inflation can be a serious problem to not only individuals, but entire countries and markets as well.
Inflation can cause markets to cease expanding, create hyperinflation on goods and services, boost interest rates, lower capital investment and impact imports and exports directly.
Market Impact
Inflation’s impact on markets can be seen far and wide. One thing inflation does to markets is cease their expansion.When goods and services of a particular country start to become too expensive for people to buy, they will stop buying. This is bad not only for the people who want the goods but also the people who are selling the goods.
Inflation can also cause hyperinflation (hyperinflation is inflation that is extremely high and out of control), under the right circumstances.
Hyperinflation is not something any country or government wants since it basically makes their currency worthless, and therefore there will little to no demand for it.
Why would anyone buy an asset that will be worth substantially less tomorrow?
When a country is expanding and their currency is appreciating, usually that will be followed by an increase in interest rates. When a sovereign national bank wants to cool their economy, they will use interest rates as a way to raise the cost of money.
Inflationary countries usually see foreign capital investments slow down considerably. As far as imports and exports go, countries with inflationary pressures will see an increase in their goods being exported since their products are cheaper to buy.
Individual Impact
Inflation’s impact on individuals not only encompasses the effects endured by a country’s economy (and therefore its citizens) but directly impacts their income, prices they pay for goods and services, and their savings, as well as directly harms those living on fixed income.Since the value of their currency is weakening, anything measured in that currency is therefore worth less. For example, someone making $50,000 dollars ten years ago could buy many more goods and services than someone making that same $50,000 now.
All in all, goods and services also become much more expensive since those products and services must appreciate just to obtain the same value.
Usually countries will see their savings rate drop, since more of someone’s budget must go to keep their standard of living the same during inflationary times.
The ones most affected by higher rates of inflation are those living on a fixed income. Their income gets devalued every time their currency takes a hit in value.
As you can see, besides making exports cheaper to the rest of the world, inflation has a very real negative effect on markets as well as individuals.
Although every country wants to have a little bit of inflation, anything above their target rate will be a harm to not only their market as a whole but to their individual citizens as well.
Tools to Control Inflation
Controlling inflation, whether it is too high or too low, can be detrimental to the health of an economy.
Although most of the measurements of inflation fall to a sovereign country’s labor department, the role of that country’s Federal Reserve (or national bank) is to control inflation through the use of monetary supply, exchange rates and fiscal policy.Monetary Policy
The primary tool for any national bank or entity trying to combat inflation would be the use of monetary policy, or more specifically, the amount of money supplied to an economy.Most central banks like to have a low level amount of inflation, usually in the neighborhood of 2% to 5% annually. Here in the United States, this responsibility falls onto the Federal Reserve.
The Fed will set the exchange rates to effect the amount of money being supplied to the economy.
When the Fed sees real inflationary concerns, they will raise the exchange rate high enough to slow the amount money being pumped into the system.
Changing Exchange Rates
Another more direct way to change the value of a currency is to change the exchange rates of that currency.Most countries let their currency trade freely against other currencies.
When a country sees the value of their currency start to fall quickly, they can use what is called a fixed rate exchange. A fixed rate exchange will peg a currency to another currency, usually to one that is stronger in value.
A good example of this would be how the Chinese have their currency fixed to the US dollar. If the Chinese were to let their currency trade freely, the yuan would appreciate quite a bit in a short period of time.
Fixed rate exchange currencies have been popular lately, especially after the Bretton Woods agreement broke down in the 1970s. Another use of currency exchange rates is to artificially “prop up” a currency.
Some national banks have intervened in their falling currency by buying huge amounts of their currency, therefore propping up the value and limiting inflation.
Fiscal Policy
Fiscal policy is basically the revenue generating policies of a government. Most governments have only two ways to increase fiscal policy: taxation and borrowing.The primary objective of fiscal policy is to maintain price stability and promote economic growth and employment of a country.
The use of excess taxation and borrowing can weaken a currency, as their future obligations become unmanageable and therefore decrease the attractiveness of that country’s currency worldwide.
Also, countries can use fiscal policy to dampen a rapidly expanding country by raising taxes and limiting demand.
Wage & Prices
Another way to combat inflation is through the use of wage and price controls. These are temporary measures, most often used during times of war and extreme hardship.If not used in conjunction with other fiscal policies, wage and price controls usually make a bad situation worse.
How to Invest During High Inflation
There are many different ways to invest to during high inflationary periods. Depending on whether you are a retiree, new investor or are just trying to limit the effects of inflation on your portfolio, there are a couple of things you can do.
From currency diversification to investing in real estate or commodities to holding precious metals, one has many different avenues to hedge against inflation.For this piece, we will look at the options available to ordinary investors looking to ride out the evil effects of rising inflation.
Treasury Inflation - Protected securities
One thing that an investor can do to limit the harmful effects of inflation is to own Treasury Inflation Protected Securities, or TIPS.If you live in the United States and have mostly US-based assets, there are a couple of different ETFs you can buy. TIPS are a treasury security that are indexed against inflation, and are usually considered relatively safe investments since they are backed by the full faith of the US government.
TIPS will be indexed to the Commodity Price Index (CPI) and their par value will increase or decrease as the CPI does.
TIPS come in a variety of maturities, from 5 to 20 years. There are also TIPS for most industrialized countries, and can be purchased directly through the issuing government. Usually these will be tax free from state and local authorities.
Gold & Silver
One thing that has come back into favor with inflation hawks is to own precious metals like gold or silver.Gold has historically had a 10:1 relationship with bond prices, which makes a great hedge in times of uncertainty. Also, the price of gold has been denominated in US dollars.
So, any sort of inflationary pressures that have the price of the dollar going up will also have the prices of gold going up. Also, times of high inflation are usually accompanied by times of panic and uncertainty. Gold has a tendency to gain favor in these times as a flight to quality or safe haven asset.
Currencies
Another, more direct way to combat inflation would be to dump all high inflationary currencies for those with lower inflationary concerns. If you know that your currency is about to – or is going through – a high inflationary period, one can simply sell their high inflation currency for something with a lower inflationary outlook.Not only will you save money by not letting your portfolio crumple, but you should see some appreciation in the other currency as well. Many investors have been getting out of dollars lately and buying the Swiss Franc or Australian Dollar.
Commodities & real estate
Another thing people do to fight inflation is to buy goods that should appreciate under inflationary times.Assets like real estate and commodities have shown tendencies to appreciate when the value of the currency they are denominated starts to fall. The goods have to appreciate in order to keep the value they would have lost since the currency went down.
The best example of this would be all the commodities (based in dollars) that have appreciated over the past two years as the US dollar has depreciated.
These are just some of the investments available to investors during time of high inflation. Again, depending on where you are in the investing cycle will determine what hedging method is best for you.
About the Author
Hank King has worked in the financial industry for the past ten years as a commodity broker and trader at the CBOT.Hank graduated from the University of Arizona with a bachelor of fine arts degree. Hank has written articles for Inside Futures, Investopedia, Traders Log and is routinely quoted in Bloomberg and other financial publications.
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