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What Is Inflation? [And Why You Should Care]

Defensive Trading

June 28, 2022

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What Is Inflation Anyway?

Anyone following the news lately will probably be wondering, What Is Inflation? After all, it seems to be all that anyone discussing the Economy is talking about. Well, Inflation is defined as

Effectively that means that Inflation deteriorates your purchasing power. During periods of higher inflation, you will be able to buy less for $1 than you were previously able to. The higher the percentage of inflation, the faster and more severe the erosion of purchasing power.

For more on Economic Fundamental Analysis, check out our related post 10 Fundamental Analysis Indicators For Defensive Trading.

Why Does Inflation Happen?

When asking the question, What Is Inflation? It is important to understand why Inflation happens in the first place.

There are many instances of Inflation (or Hyper-Inflation) from throughout history which are real cautionary tales for Economists and Governments today. For example, the Price Revolution in the 17^th Century economy of the Kingdom of Spain whereby Inflation effectively collapsed the economy without them even being aware that it was taking place. Then there is the worst case of hyperinflation in history which occurred in Hungary in 1946. Inflation peaked at 41.9 quadrillion percent (41,900,000,000,000,000%) a month, which in daily terms meant that priced doubled every 15 hours.

For this reason, Governments are constantly tracking the Inflation rate.

There Are Three Key Reasons Why Inflation Happens:

1. Cost Push Inflation – costs of businesses rise, and the costs are pushed onto customers. This can be for many reasons, such as the costs of raw materials increase, or due to Union movements demand higher wages for employees. Conversely, there may be a shortage of workers as the UK is currently experiencing with the HGV deriver shortage that has plagued the second half of 2021.
2. Demand Inflation – This takes place when there is simply an increase in the number of people who are demanding a product and the supply cannot keep up. This can often happen when people in the economy are feeling wealthy and are happy to spend their money. This often happens due to either a) cut in the tax rate, providing people with more disposable income to spend that they would otherwise have had; or b) a cut in the interest rates allowing people to take out loans at a lower rate.
3. Government’s Printing Money – Governments want to stimulate the economy in order to ensure that there are enough jobs for the citizens. They can do this in two ways. Firstly, by literally increasing the number of notes in circulation by physically printing more money and injecting it into the system. Secondly, they can increase Government debt or allow Banks make bigger percentage value loans on the same security.

The key issue with the second and third points above is that there is more money circulating the financial system, however, all the additional money is still chasing the same number of things to buy. This means that simply put, if demand is out stripping supply, the prices increase. That’s Economics 101. So, there is more money, but it isn’t buying anymore.

As the Economist John Maynard Keynes stated: “A bit of inflation can grow the economy“. This is because there is a sweet spot in the timeline when there is more money in circulation, but the prices of the goods and services have not yet responded to the increase in demand by increasing. During this period, businesses have more access to capital which can see them use it for expansion and therefore increasing their output.

This is amazingly beneficial for the Economy as it means that there are now more goods available for the consumer to purchase than before, which should, in theory, steady the ship longer term. However, this idea is more theoretical as Economists and the Central Banks of an economy who are charged with managing inflation and growth are only truly able to react to the developments one they have happened and are therefore usually one step behind the reality of the situation. In addition to this, most economic policies are based on modelling and are therefore, effectively, guesstimates of what should happen in real life.

What’s The Big Problem With Inflation Anyway?

When considering What Is Inflation?, the next thing to consider is what is the big problem with Inflation?

The main issue with inflation is that not all areas of the economy increase at the same rate over time. In fact, it is more common to see wages stagnate and the cost of goods and services increase much faster.

In addition to that, inflation is terrible for savings held in the Bank. If you think about it this means that if you are inclined to save money, you can see a reduction in the real purchasing power of how much you have in the bank simply by letting it sit there.

So, what can we do?

How Governments Control Inflation?

Now that we understand What Is Inflation?, the next logical question is, what can we do about it? Well it’s not us directly who do something about it, it’s the Central Bank. Central Banks and to a lesser extent the Government are charged with keeping the Economy stable, and this includes controlling inflation. It usually falls to the Central Bank to do this, and they can do it in one of three ways:

1. Sale of Government Bonds – Bonds are certificates issued by the Government that is effectively a way of locking in long term loans from investors. Bonds state something to the effect of: you can buy the Bond today for $100.00 and in 10 years, you will have been repaid $1000.00. This makes this type of investment attractive for investors as they are generally very safe investments to take out. In this instance, the outcome is that cash in circulation in the economy is taken out of circulation and stored in the Central Bank instead.
2. Interest Rates – When interest is very low, like 1.00%, people who are taking out loans don’t find the interest repayments very difficult to meet. In that instance, people are very keen to take out loans and there is significant amount capital circulating the economy as a result. On the flip side, if the Central Banks decide to raise interest rates, these increased rates are then passed onto the consumer via the Banks that lend to people. If this happens, people who would have otherwise rushed to borrow money are unable to do so as the interest repayments are far too onerous and preclude them from being able to access the additional capital. The result of this is that there will be much less money circulating the economy as people don’t take out loans to begin with, or those that do take out loans are obligated to relay a significant amount more to the lender than before.
3. Cash Reserve Rate – Banks are required to maintain a specific level of cash on hand so that when everyday people go to the ATM to withdraw some of their money, they can do so. It is, however, not up to the Bank itself what the Reserve Rate is, it is up to the Central Bank. The Central Bank dictates to the Banks how much they need to keep on hand and can therefore require the Banks to hold more cash than what they previously did. This will result in the Banks keeping additional funds in their reserve than what they did before, resulting in less cash circulating the economy.

All of the above methods cause less cash to be in the economy.

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What Should I Expect To Happen To The Markets During Inflation?

OK, so now we know What Is Inflation? and we have some idea of why is it can be so damaging to an economy. So, the next big question is, how do we attempt to protect ourselves from the effects of Inflation.

During periods of high inflation you should expect the Stock Market to fall as real returns for the investor tumble (sometimes to almost zero). You should also expect the prices of commodities to increase, often to a point of potential unaffordability for those on the lower end of the wages scale. In addition, the housing market usually falls as banks are lending less and increased interest rates are preventing many would-be borrowers from entering the market. You should also expect the demand for Bond prices to fall as the real returns investors are receiving from them will fall, also potentially to zero.

As Warren Buffet has indicated on many occasions, a period of inflation in an economy is a terrible time to be an investor. It may, however, be a fantastic time to be a trader. Why? Well because during periods of higher inflation, may investors need to divest themselves of many of their previously held assets due to the increase in debt repayment caused by higher interest rates. This usually has a huge increase in the level of Volatility in the prices of assets.

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