On this blog, you already heard about inflation. And if you follow other personal finance blogs, you have probably heard a lot about it. But do you know exactly what it is? And especially, do you know what causes inflation and what it does to your personal finance?
Inflation is caused by many things, it can come from the economy, from the government or for simple demand and supply effects. It can even be negative, something that is called deflation. And it has several effects, the biggest of which is to make you lose purchasing power over time. You need to protect yourself against inflation.
In this post, we are going to look in details at all these causes and effects of inflation. And we are also going to look at some examples of inflation in the past.
First of all, inflation is different for each currency. Generally speaking, this can be generalized as inflation for each country. But for countries that share the same currency, such as many countries from the European Union, this is a bit more complicated.
In general, inflation is related to a country and its currency. For instance, it is not the same in Switzerland or in the United States. Historically, it has been higher in the United States than it has been Switzerland.
More specifically inflation is the rate at which the price of things evolves. If the price of things increases, there is inflation. This is directly related to your purchasing power. If there is inflation, your purchasing power will decrease. If today, 100 dollars buy you 100 eggs, tomorrow it may buy you only 99 eggs. There has been inflation in the price of eggs. That means that the same 100 dollar note is not really worth as much as before.
There are a few specificities as to how to compute the inflation rate. First, you can compute the inflation for each product independently. For instance, the inflation rate of butter or oil. This is fairly easy. But generally, you are interested in the average inflation for many products. What is generally used is a weighted average over different products.
And unfortunately, there are many different possible ways to compute this average inflation. Most countries have an official metric for inflation. For instance, the most used index in the United States is the Consumer Price Index for all Urban Consumers (CPI-U). To compute this index, they survey many people and compute the rate based on their consumption. For instance, people use one percent of their money on rice, the inflation of rice will make up one percent of the index. In Switzerland, it is mostly computed in the same way and called the Consumer Price Index (CPI).
For instance, here is the inflation in the United States in the last 50 years or so:
In the 1980s, inflation was really high. For several years, it was at more than 10%. This is a really high rate. Since 1992, inflation has been oscillating between two percent and five percent. It has only been negative for a few years.
For comparison, here is the inflation in Switzerland for the same period of time:
As you can see, Switzerland inflation rate has historically been significantly lower than in the United States. Since 1992, it always stayed between two percent and negative two percent. It has been negative several years in a row in the last ten years. These last few years, it has always been very low.
Contrary to what a lot of people think, inflation can be negative. In that case, that means that the price of the things in the country are actually decreasing. Negative inflation is also called deflation. This is a great thing for people living in the country. But it may not be a great thing for businesses of the country. In Switzerland, we had several years where inflation was negative in the last years.
It is actually quite rare to have deflation on the entire country. However, it is quite common for one product to decrease in price. For instance, things like wheat or milk have consistently gone down in price.
We will see later that while this seems a very good thing, it may not be the case for everybody. It can cause the bank yields to go down and can have negative effects on the economy.
Causes of inflation
You may wonder why there is inflation? It does not happen without reason. In fact, there are many reasons for inflation to occur. Some of these reasons only apply to a few products and some of these apply to the entire purchasing power.
One thing that can drive the price up is the increase in demand. For most things, the demand increase as the number of people increased. There is a finite resource of most things on earth and yet there are more and more people. This causes an increase in prices for some goods. Some goods also become suddenly more demanded, for many possible reasons. And, of course, this can also go the other way. If the demand for one good goes down, it is likely that its price will go down as well.
Not only can demand have an effect on price, but supply can also have an effect. Obviously, too much supply may drive the price down. On the other hand, limited supply can drive the price up. And sometimes, supply becomes more difficult, once again driving the price up. As said before, many things exist in a finite supply. And it can become more and more difficult to gather more of them.
One other possible reason is also that the government is printing too much money. If there is much more money, the value of the money decrease and thus the prices increase. This is generally extreme cases because the government will tend to avoid this situation. But there have been some extreme cases in the past. For instance, the currency in Germany after the first World War was almost not worth anything more. And recently there have been some very high inflation in Venezuela. These extreme cases are sometimes called hyper-inflation. This is never good!
This can of course only happen when the currency is not backed by any physical assets. These currencies are called fiat currency and they are the most common today. In the past, most currencies were backed by gold. For instance, the dollar was backed by gold until Richard Nixon changed this policy in 1973. Currently, there are still a few small currencies backed by oil. In that case, there is another factor that can make the currency lose value or gain value. If the physical asset price varies, so does the price of the currency. And so do the prices of the goods purchased with this currency. This is more historical since you are probably not concerned with this fact.
When there is inflation, there is also some pressure from employees to get raises in salary. That way, they can continue having the same purchasing power. Most companies will give a raise if inflation is strong. It will be most likely below the real rate. But it can still be a significant raise. However, now companies have to pay more. And often, to continue having a good margin, they increase their prices consequently. And this will drive inflation up once again. This is a bit of a vicious cycle. If there was no inflation and no raise, nothing would change. But this is not the only reason, as we saw before.
Consequences of inflation
The main consequence of inflation is that you are losing purchasing power over time. If you think you need to save one million now to retire in 20 years, your one million may not be enough once the 20 years have passed. It could be only 80% of the target for instance.
Some people are thinking that inflation is making them lose money. This is not really accurate. In fact, your money does not change. You are just able to do less with the money as inflation plays its role.
Also, some people believe that only money in the bank is subject to inflation. But this is entirely false. Money under your pillow is equally subject to inflation as the money on your bank account. In fact, it is even worse for the money under pillow since your bank gives you some interest while your pillow does not! If your pillow gives you interest, please tell me about it!
So the main consequence is that your hard-earned money is allowing you to purchase less and less. You are losing purchasing power. This is quite sad. You probably worked very hard for that money!
Inflation can also have some positive effects. We do not talk a lot about them since most people focus on the negative side, but they are there nonetheless.
The first positive effect is for people holding assets that are subject to inflation. The best example is for a house. If there is a good inflation rate in the real estate market, your house will appreciate. If you sell it ten years later, you may have done a nice profit. But do not forget that if you need to buy a new one after you sold the first, you may also need to buy it at a higher price.
The second positive effect is for the economy. If the inflation rate is very low or negative, there is no difference between spending and saving. However, if there is higher inflation, spending can be seen as more efficient than saving since you bought something at a smaller price than you would have if you waited longer. This promotes spending in the entire country and thus helps the economy. This is why inflation is not always a bad thing. However, a very large inflation rate is not a good thing. In that case, people will start to stop spending, the economy will go worse and the price may increase even more consequently.
Relation to yield
Generally, you hear talking about inflation and bank yield together. The reason is in fact quite simple. Bank yields and inflation are often following the same paths. That is not to say that yields are the same as inflation, not at all. But when inflation is high, the yield is generally high. And when it is low, so are yields. For instance, in Switzerland, it has been quite low in the last years. And now, as a result, the yields are actually extremely low, often zero for most banks.
This is because the basic treasury yield is managed by federal banks. For instance, in the United States, this is decided by the Federal Reserve and in Switzerland, this is managed by the Swiss National Bank (SNB). They may decide to increase or decrease the yields based on the situation of the current economy.
We saw before that inflation has several effects, some positive and some negative. The federal banks want to keep its rate in check and want to keep the economy running as good as possible. Sometimes, this means they have to lower the yields or increase them. Most of the time, they want to make people spend more. Because this is good for the economy and a good economy is good for the people. Of course, there are many other factors that can make them change the yields, not only inflation. And increasing or lowering the yields can have big effects on the economy as a whole.
What to do about it?
Now that we have seen a lot of things about inflation, it is time to know what you can do about it. And in fact, this is going to be much easier.
As said before, the principal problem for simple investors is that your money is losing value for as long as it is sitting in a bank account. If today this money buys you a ton of sugar, it may only buy you half a ton in 20 years. So how do you go about buying a ton of sugar in 20 years with the same amount of money? The answer is pretty simple: you invest!
You need to invest your money in a financial instrument that will yield more than inflation. As long as your money is yielding more than the inflation rate, you will be safe and you will be able to buy a ton of sugar in 20 years. And if you are lucky with your investments and they yield significantly more than inflation, you may even e able to buy several tons of sugar. And probably pay large dentist bills if you eat all that sugar. But that is another story!
There are several financial instruments that will yield more than inflation in the long-term. The first obvious instrument is stocks. If you invest in stocks, ideally with passive investing in a broad stock market index, you can expect a yield higher than inflation. Of course, this is only historically, we are just expecting, and hoping, it to last.
You can also invest in bonds. While they are generally yielding less than stocks, they can still yield more than inflation and they are less volatile than stocks. Once again, it is better, and simpler, to invest in a broad index of bonds.
There is a special kind of treasury bond called Treasury Inflation Protected Securities (TIPS). These are bonds that pay a fixed interest rate on the principal twice a year. But the principal goes up or down with the inflation. That means you are protected from the effect of inflation. On the other hand, you are losing money if there is deflation.
And another way to fight inflation is to invest in assets whose price will also inflate. For instance, you could invest in real estate. Generally, the price of real estate assets increases over time. This is not granted and it may be decreasing depending on the situation of the real estate. For instance, a lot of houses highly deprecated after the financial crisis of 2008-2009, the so-called subprime crisis. Nevertheless, owning some real estate asset and renting it could yield more than inflation and you could be able to sell it for more than you bought it for.
As you can see by now, inflation is not a very simple subject. However, defense against inflation is fairly straightforward: invest your money. You should not let your money lose value in a bank account. You should invest it in the stock market.
Although you may think that inflation is evil, it is generally a necessary evil. It helps the economy running. And without the economy, there are no jobs, no opportunity, and no money. A healthy inflation rate is necessary for the economy. On the other hand, a large one, be it negative or positive, is never a good thing.
What do you think about inflation? How do you protect yourself against it?