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What causes inflation and what it means for you as an investor

Learning what causes inflation and its implications for you as an investor is a valuable financial guide.

A rise in prices, or inflation, means a person’s purchasing power is decreasing over time. But what causes inflation?

The rate at which people’s purchasing power declines can be approximated by calculating the average price increase of a certain set of products and services over a given time period.

Inflation in the UK reached 11.1% in October 2022, the highest level in over 40 years.

The rate of decline was also slower than predicted by the Bank of England, keeping the rate above 10% through March 2023.

A unit of money is worth significantly less now than it did in the past due to these increases in prices. But what causes inflation of this rate? And what can you do to protect against it?

In this article, we will discuss those questions and how you can protect your wealth against it.

If you want to invest as an expat or high-net-worth individual, which is what I specialize in, you can email me (advice@adamfayed.com) or use WhatsApp (+44-7393-450-837).

What is inflation?

The rate at which consumer prices are increasing is known as inflation. Inflation, which drives up the cost of living essentials like food, can have a chilling effect on the economy as a whole.

Housing, food, medical care, and utilities are all examples of necessities that might experience inflation, but so can cosmetics, cars, and jewelry.

Once inflation is widespread in an economy, the fear of future inflation becomes the primary focus of both consumers and businesses.

It is a common misconception that inflation is always bad, but it is in reality simply a measurement of how fast prices are rising. Some inflation is necessary and unavoidable in an active economy.

Inflation happens when the supply of money is increasing faster than the productivity output or GDP of a nation.

So, if there is too much money chasing the same amount of goods then prices will rise. When this happens, it can affect your ability to pay for things because you’re buying less with each dollar as costs go up.

As it is the increase in the overall price of goods and services, higher inflation means that every year, things cost more than they did in the past.

Inflation usually occurs when there are too many people trying to use money for something at once–for example, during periods of rapid growth or economic expansion when many people are looking for work and buying houses.

Inflation is tracked by the Federal Reserve and other central banks of industrialized nations. The Federal Reserve targets inflation of around 2% and responds to rapid or excessive price increases by adjusting monetary policy.

The opposite of inflation is deflation, which occurs when prices go down and people have more money to spend.

What causes inflation?

There are several potential causes of inflation, including rising demand and dwindling supply. Everyone feels the effects of inflation since spending the same amount of money now only gets you a smaller quantity of products and services than it did before inflation.

The general public associates inflation with higher prices and less disposable income. An increase in the money supply can induce inflation, which in turn raises prices across the board.

There are several factors that can influence an economy’s inflation rate. Manufacturing cost increases and increased customer demand are common causes of inflation.

While rising money supply is always at the root of inflation, its specific manifestations vary from economy to economy. There are a few ways a country’s central bank might increase the money supply.

  • Printing and releasing brand-new money into circulation.
  • Having the purchasing power of the country’s official currency formally reduced.
  • The most common method by which banks produce new money to lend as reserve account credits is through the purchase of government bonds on the secondary market.

The value of the money decreases in each of these cases. This results in inflation through three distinct channels: demand-pull, cost-push, and intrinsic.

Demand-pull inflation

In a demand-pull inflation scenario, the growth in aggregate demand for goods and services outpaces the expansion in economic output as a result of an increase in the money and credit supply. The result is a rise in prices as demand increases.

Consumer confidence rises as a result of increased disposable income. This causes more money to be spent, which drives up costs. Because of the increased demand and the less adaptable supply, prices will rise.

High levels of consumer demand can lead to price increases and in general, the prices of commodities across an economy will rise if there is a spike in demand for those goods.

What causes inflation can be a variety of factors, ranging from available supply of goods, the demand for those goods, monetary and fiscal policies, and the value of the US dollar.
What causes inflation can be a variety of factors, ranging from available supply of goods, the demand for those goods, monetary and fiscal policies, and the value of the US dollar. | Photo: Pixabay

Prices tend to rise regardless of whether there is a supply or demand gap in the short term, but persistent demand can lead to demand-pull inflation.

When unemployment is low and incomes are increasing, consumers are more likely to spend money. Rising demand for goods and services is a direct result of an expanding economy and its citizens’ disposable income.

There is less of a commodity or service available to meet rising demand. According to the law of supply and demand, prices rise when there are fewer of a certain good or service available and higher demand from buyers. Demand-pull inflation is the end effect.

Inflation can also be caused by businesses, particularly if they provide goods that are in high demand. If customers are willing to pay more, then the corporation can do so.

When the product being sold is something essential to people’s daily lives, such as gasoline or electricity, corporations have no qualms about jacking up the price. However, it is consumer demand that gives businesses the power to increase prices.

Cost-push inflation

When prices rise and ripple through the inputs used in production, cost-push inflation occurs. Costs for a wide variety of intermediate items go up when newly created money and credit are pumped into commodities or other asset markets.

The impact of a negative economic shock on the supply of essential commodities is illustrative of this phenomenon.

Basically, whenever production costs increase, such as raw materials and wages, the result is cost-push inflation.

Rising costs of oil and metals, which are both essential industrial inputs, are one indicator of impending cost-push inflation.

As production costs rise, there is no change in consumer demand, but there is a decrease in available goods. The upshot is higher prices for the final products as a result of covering the higher production costs.

These changes result in greater production costs, which eventually make their way into higher retail pricing for consumers.

For instance, an increase in the money supply might lead to a surge in oil prices due to speculation. Thus, energy costs can go up and add to inflation, which shows up in various measures of consumer price growth.

As another example to illustrate, if the cost of copper goes up, manufacturers may decide to charge more for the products they rely on copper to create.

Higher costs of raw materials will be passed on to customers if product demand is unrelated to copper demand. As a result, consumer prices rise without corresponding increases in demand.

Built-in Inflation

Inflation that is “built in” occurs when individuals anticipate that the rate of inflation will remain the same in the future.

As the cost of living increases, so do people’s expectations that it will continue to increase. Workers may seek increased compensation or costs as a result. Their higher wages drive up the price of consumer products, and the cycle continues as one cause encourages another.

Production costs are impacted by wages, which are often a company’s largest expense. Shortages of labor or workers are possible when the economy is doing well and the unemployment rate is low.

In response, businesses have had to raise wages in order to compete for skilled workers, driving up the cost of manufacturing. Cost-plus inflation happens when a corporation raises prices to compensate for rising labor costs.

Expense increases might also result from natural calamities. If a hurricane wipes out maize crops, for instance, the cost of various goods may increase as a result.

When widespread public expectations for future inflation persist, built-in inflation becomes the result. As the cost of living rises, the general public may start to expect it to keep going up at the same rate. It’s reasonable to assume that workers will seek salary increases as a result of these widespread projections of future price growth.

Businesses may pass on the added expense of raising wages to their customers. With more money in their pockets, customers may spend more on the things they want, driving up costs. When one factor feeds back into another, it can start a wage-price spiral.

Residential Real Estate

The real estate industry has had both boom and bust periods. Home prices increase when demand is high due to an expanding economy.

The demand also affects tertiary industries that supply the construction and maintenance of homes. Increased demand for housing could lead to greater demand for construction materials like lumber, steel, and even the nails and rivets required in building construction.

Fiscal and Monetary Policy

Governments that engage in expansionary fiscal policy can boost corporate and individual spending discretionary funds.

Companies may invest the savings from tax reductions in equipment upgrades, wage increases, and new hires. Potential buyers may also buy more merchandise.

Increasing public investment in infrastructure is another way for the government to stimulate the economy. As a result, there may be a spike in demand for goods and services and consequently higher prices.

Inflation can be stoked by both loose monetary policy and expansionary fiscal policy. Interest rates can be lowered by central banks through an expansionary monetary policy.

When central banks like the Federal Reserve reduce the cost of lending, commercial and retail banks have more capital to lend out to borrowers. Spending and demand for goods and services rise in response to an increase in the economy’s total supply of money.

Depreciation of the Dollar

The value of money, like the value of any other commodity, is said to be determined by market forces of supply and demand. The value of something decreases as its supply increases. If the value of money decreases, its ability to buy goods and services decreases, and they become relatively more expensive.

The equation of exchange, which summarizes QTM, asserts that nominal expenditures in an economy equal the money supply multiplied by the annual rate at which money is spent (the velocity of money): MV = PQ.

Therefore, given a constant supply of goods in the economy, an increase in either the money supply or the velocity of money can lead to a rise in P (prices).

When people stop trusting the currency’s issuer, the value of the currency drops. If people start to believe that money has no value at all, hyperinflation could result.

How does inflation affect you and your finances?

When inflation occurs, it has an impact on your money as inflation means a decrease in the purchasing power of your money. That means that if there is inflation, your money will be worth less over time.

For example, if you had saved $100 and put it into your savings account at an interest rate of 5%, after one year you would have $105. But if there was an increase in prices during that year, of say 2%, then after one year your savings would only be worth $102.

Inflation also affects other parts of your finances like wages and investments. If you are paid a salary or receive dividends from stocks, then these payments will become less valuable as inflation increases because they might not keep pace with rising prices for goods and services.

While it’s simple to track the cost of a single good or service over time, the reality is that people have complex requirements. In order to provide a high standard of living, individuals require access to a wide range of products and services.

Food, metal, fuel, energy, transportation, and services like healthcare, entertainment, and labor are all examples of such things. A rise in prices means you are buying less with each dollar, which affects your ability to pay for such things.

Inflation hurts those that depend on fixed incomes like pensions and Social Security the most. | Photo: Pexels
Inflation hurts those that depend on fixed incomes like pensions and Social Security the most. | Photo: Pexels

Inflation also tends to erode spending power for people on fixed incomes like retirees or those who live on Social Security benefits each month. The reason is that inflation is a tax on savings and investments, but it’s also a tax on wages because it reduces the purchasing power of your paycheck.

The point of calculating inflation is to assess the aggregate effect of price shifts over a broad range of goods and services. It provides a uniform numerical depiction of the general upward trend of prices across all products and services in an economy over time.

When prices go up, less can be purchased with the same amount of money. The general public’s cost of living is affected by this decline in purchasing power, which slows economic expansion as a whole.

Economists agree that persistent inflation happens when a country’s money supply expands faster than its economy.

To counteract this, the monetary authority (often the central bank) regulates the money supply and the availability of credit to maintain stable prices and a robust economy.

In the United States, the Federal Reserve has policy-setters that would monitor inflation closely. They want inflation at levels that help sustain a strong economy but not so high that it gets out of control and threatens the economy’s stability.

Financial institutions like the Fed have a primary job of keeping economies growing at a healthy pace.

They watch inflation closely because it can destabilize the economy by causing people to lose faith in the value of their investments, and spend less money, which leads to fewer sales for businesses and slower growth for the overall economy.

More importantly, high inflation erodes public trust in the government and incites unrest, which can signal political or socioeconomic instability in a country.

Inflation is measured by looking at changes in consumer prices over time (CPI). The ideal range for CPI is between 2% and 3%, according to most economists.

Anything below 1% could be considered deflationary, or when prices fall, which can create higher unemployment because businesses earn less due to decreases in demand, and a decline in overall economic activity.

Anything above 4% could be considered hyperinflationary, where money loses its value quickly as prices rise faster than wages or income levels can adjust accordingly.

Different types of goods and services result in different measures of inflation. Keep in mind that disinflation, another name for a decrease in the pace of inflation, is not the same thing as deflation.

In economics, monetarism is a well-known hypothesis that attempts to explain the link between money creation and price increases.

For instance, when the Spanish conquered the Aztec and Inca empires, they flooded the European economy with gold and silver. The rapid expansion of the money supply led to a decline in the purchasing power of currency, which in turn fueled rapid price increases.

How should you invest to protect against inflation?

Inflation refers to a widespread and persistent rise in prices from one year to the next across all sectors of an economy.

The rate of inflation is a key economic concept because it reflects the rate at which the real worth of an investment declines and the purchasing power of a currency declines over time.

With inflation as a guide, investors can calculate the required rate of return on their portfolio in order to keep their standard of living constant.

When the quantity of money grows faster than the economy’s ability to produce goods and services, inflation results. Whenever there are more buyers than sellers, prices tend to go up. The value of one unit of currency decreases as a result of this event.

With this in mind, savers and investors should seek for financial instruments offering returns at or above the rate of inflation. If inflation was 5% and ABC stock returned 4%, the real return on investment would be -1% (5% – 4%).

Liquid assets, like any other asset, are affected by inflation, however their value appreciation is often slower than that of other assets. As a result, liquid assets are more susceptible to inflation’s overall negative effects. In general, people and corporations reduce their stockpiles of liquid assets as inflation rises.

Assets that are difficult to sell have a natural defense against inflation if they increase in value or earn interest. Most employees invest in securities like stocks, bonds, and mutual funds to protect their savings against inflation.

When prices rise at an alarming rate, many people invest their cash or withdraw it to buy necessities rather than risk losing purchasing power.

You can hedge against the effects of inflation on your buying power and profits on investments by acquiring inflation-indexed bonds or Treasury inflation-protected securities (TIPS). These investments track inflation and are so protected from its effects.

Lenders and borrowers alike can benefit from inflation. If a borrower owes money before inflation, they benefit from inflation. However, this must coincide with a raise in pay. Because of the rise in prices, the interest rate that lenders charge on loans is likewise worth more to the lender.

Gains on investments are worthless if they don’t keep up with inflation, therefore investors need to make sure their returns are at least that high.

Similarly, people should work to have their earnings increase annually by at least the rate of inflation, or risk actually seeing a decline in their purchasing power.

There are also other ways to safeguard oneself from inflation:

  • Protect yourself from inflation with a 30-year fixed-rate mortgage that offers a low interest rate. Borrow money when rates are low, and if they decline, think about switching loans.
  • Purchasing Stocks: The stock market typically outperforms the bond market when inflation is high because corporations may pass on price increases to their customers. Companies that manufacture necessities or commodities tend to be safe investments. However, as interest rates rise alongside inflation, bond prices fall.
  • Invest in bonds that are resistant to inflation. Treasury Inflation-Protected Securities (TIPS) are a type of financial asset whose value rises and falls in tandem with the Consumer Price Index (CPI) to account for inflation. Inflation can be taken into account with the help of a cost of living adjustment (COLA) rider in some permanent life insurance policies and annuities.
  • Put away money while rates are high: Put your money into a money market account or a certificate of deposit where the interest rate is higher. It’s important to keep in mind that you’ll still experience a loss of purchasing power if the return turns out to be lower than the rate of inflation.
  • Invest in a hedge against inflation. Gold and real estate, for example, are widely regarded as safe havens that will appreciate in value alongside inflation.
  • Investment property ownership: Landlords can usually increase rents to keep up with inflation. This is especially helpful for those who have a fixed-rate mortgage on an investment property.

How do you measure inflation?

There are several different measures of inflation, but the two most commonly reported are the Consumer Price Index, Producer Price Index, and Personal Consumption Expenditures.

A country’s inflation rate is the percentage change in its consumer price index over time; this should not be confused with individual prices or costs, which may rise or fall faster than average while still contributing positively or negatively towards their respective categories’ overall growth rate.

The Consumer Price Index is widely used because it provides a broad overview of inflation across a wide range of consumer categories. Price changes in this basket, then, are representative of inflation in general.

The Consumer Price Index is frequently utilized as the economic indicator of choice when gauging inflation.

The Consumer Price Index tracks changes in prices paid by consumers for retail goods and services but excludes income earned from savings and investments and the money spent by tourists.

The Producer Price Index tracks price changes experienced by domestic producers and is thus another indicator of inflation.

Monitoring the prices of a set of products is the simplest way to measure inflation. | Photo: Pixabay
Monitoring the prices of a set of products is the simplest way to measure inflation. | Photo: Pixabay

Fuel, agricultural goods like meats and grains, chemicals, and metals are all included in the PPI’s price index. If the consumer feels the effects of the price hikes that drove up the PPI, it will show up in the CPI.

The Producer Price Index tracks inflation from the perspective of those who actually create goods and services, by looking at how much money they make on average. Meanwhile, consumer price index measures prices from the consumer’s perspective.

Another inflation gauge is the personal consumption expenditures index, which measures the rate of change in the total amount people spend on goods and services for their own use.

The PCE Price Index includes a much wider variety of purchases than the CPI’s basket of items does, and it is weighted using information from regular business surveys, which are generally more trustworthy than the consumer surveys used by the CPI.

There is also the GDP deflator, or the GDP price deflator, a metric developed by the Bureau of Economic Analysis of the United States to measure the general degree of inflation in the economy.

The GDP deflator incorporates both the Consumer Price Index and the Producer Price Index into a single measure of national output prices.

Several factors have been proposed by economists as generators of inflation. When production costs rise, the aggregate supply of goods and services contracts; this is known as cost-push inflation.

Raw material and labor cost increases may also contribute to demand-pull inflation. Built-in inflation is hypothesized to occur when people anticipate price increases, leading to salary increases. In addition to loose fiscal and monetary policy, supply or demand shocks can also lead to price increases.

How can you benefit from inflation?

Borrowers with lower fixed interest rates and owners of assets that rise with inflation benefit the most from inflation. With inflation, the interest payments on these obligations will cost less of a percentage of their original value.

Holding assets in markets that are susceptible to inflation might be beneficial for investors. If energy costs are on the rise, for instance, investors in the energy sector may benefit from rising stock prices. Inflation tends to improve the performance of value equities relative to growth stocks.

Lenders and borrowers alike can benefit from inflation. If a borrower owes money before inflation, they benefit from inflation. However, this must coincide with a raise in pay. Because of the rise in prices, the interest rate that lenders charge on loans is likewise worth more to the lender.

The victims of inflation are usually savers and lenders. There is a loss of purchasing power for savers as interest rates rise, and a loss of value for borrowers whose loans are fixed at lower rates.

Inflation harms buyers as well as sellers since prices rise across the board. Because they spend a larger share of their income on basic needs than do those with higher incomes, those with lower incomes may feel the effects of inflation more acutely than those with higher incomes.

Bottom line

Inflation is one of the biggest economic concerns for investors and policymakers alike. It can cause serious problems for people who rely on fixed incomes, like retirees or those who live on Social Security benefits each month.

Workers are paid more stringently as wages rise but consumers also tend to demand higher-priced goods when they see that businesses are charging more for their products.

If you need more guidance on how to protect your wealth against rapid inflation, consider seeking the services of a professional financial planner.

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Adam is an internationally recognised author on financial matters, with over 760.2 million answer views on Quora.com, a widely sold book on Amazon, and a contributor on Forbes.

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