Breaking it Down: Let's have a conversation about inflation. (Finally)
Welcome to 'Breaking It Down,' where we embark on an enlightening journey into the world of futures, commodities, bonds, equities and more! In this edition, we shift our spotlight to inflation.
I think it’s important to understand the different schools of thought on inflation. If you asked an “academic” how they would explain inflation…
To them it is a fundamental economic concept that affects individuals, businesses, and governments.
Demand and Supply: Inflation is primarily influenced by the interaction of supply and demand in the economy. When demand for goods and services exceeds their supply, prices tend to rise. Conversely, when supply outpaces demand, prices may fall or remain stable.
Key Drivers of Inflation:
Demand-Pull Inflation: This occurs when demand for goods and services increases faster than their supply. It often happens during periods of economic growth, increased consumer spending, or government stimulus. As demand rises, producers may raise prices to balance supply and demand.
Cost-Push Inflation: This results from increased production costs, such as rising wages or higher raw material prices. When businesses face increased costs, they may pass those costs on to consumers in the form of higher prices.
Built-In Inflation: Sometimes called wage-price inflation, this occurs when workers demand higher wages to keep up with rising prices. When businesses pay higher wages, they often raise prices to cover the increased labor costs. This creates a feedback loop of rising prices and wages.
Measurement: Inflation is typically measured using price indices, with the Consumer Price Index (CPI) and the Producer Price Index (PPI) being common examples. These indices track changes in the prices of a basket of goods and services over time.
Effects of Inflation:
Reduced Purchasing Power: As inflation erodes the value of money, individuals and households can buy fewer goods and services with the same amount of money. This reduces their real income and purchasing power.
Uncertainty: High or unpredictable inflation can create economic uncertainty, making it challenging for businesses and individuals to plan for the future.
Interest Rates: Central banks often adjust interest rates in response to inflation. Higher interest rates can help control inflation by reducing borrowing and spending, but they can also slow economic growth.
Income Redistribution: Inflation can affect different groups of people differently. Borrowers may benefit from lower real debt burdens, while savers may see the real value of their savings decrease.
Types of Inflation:
Moderate Inflation: Many central banks target a moderate level of inflation, such as 2% annually, as it can promote economic growth and prevent deflation (a sustained decrease in prices).
Hyperinflation: This is an extremely high and typically accelerating rate of inflation, often exceeding 50% per month. Hyperinflation can have devastating effects on an economy and is usually caused by factors like excessive money printing and loss of confidence in the currency.
Government and Central Bank Role: Governments and central banks often employ various tools to manage inflation. These tools include adjusting interest rates, controlling money supply, and implementing fiscal policies (taxation and government spending) to influence overall demand in the economy.
I learned from the Austrian school of economics and this is where I differ from main stream economics. Austrian economists approach inflation from a different angle compared to mainstream economics. Here's how Austrian economics typically thinks of inflation:
Inflation as a Monetary Phenomenon: Austrian economists, like many other economists, view inflation as primarily a monetary phenomenon. They understand that inflation occurs when there is an increase in the money supply that outpaces the increase in goods and services available in an economy. In this view, inflation is fundamentally a result of excess money creation by central banks or governments.
A Focus on the Money Supply: Austrian economists emphasize the importance of the money supply, particularly the expansion of the money supply through practices like fractional reserve banking and central bank interventions. They argue that when new money is created without a corresponding increase in the production of goods and services, it leads to a devaluation of the currency, which manifests as rising prices.
Subjective Value Theory: Austrian economics is known for its subjective theory of value, which suggests that the value of goods and services is determined by individuals' subjective preferences and assessments. Applied to inflation, Austrian economists argue that rising prices are a reflection of changes in individual preferences and choices in response to changes in the money supply. In other words, inflation is not just about prices going up but also about people adjusting their behavior and choices due to changes in the value of money.
Distortions in Economic Calculation: Austrian economists emphasize the harmful effects of inflation on economic calculation and resource allocation. They argue that inflation disrupts the price signals that help individuals and businesses make rational economic decisions. When prices are distorted by inflation, resources can be misallocated, leading to inefficiencies in the economy.
Negative Consequences: Austrian economists tend to emphasize the negative consequences of inflation, such as wealth redistribution, as it erodes the purchasing power of money. They argue that those who receive new money first, often banks and well-connected entities, benefit at the expense of those who receive it later, including wage earners and savers.
The Role of Sound Money: Austrian economists advocate for the use of sound money, typically gold or a currency backed by a commodity, as a means to prevent inflation. They believe that a stable and non-inflationary monetary system is essential for economic stability and prosperity.
Malinvestment: The Austrian theory of malinvestment- when central banks or governments artificially lower interest rates or inject excess money into an economy, it distorts the natural allocation of capital. In response to these artificially low rates, businesses and investors may make decisions that appear profitable in the short term but are unsustainable in the long run. This leads to resources being misallocated into sectors or projects that wouldn't have been economically viable under normal market conditions. When the artificial stimulus eventually recedes or interest rates rise to their natural levels, these malinvestments are exposed, leading to economic imbalances, financial crises, and often a painful period of adjustment as the economy restructures itself to correct the distortions caused by the initial intervention. The Austrian theory of malinvestment underscores the importance of market-driven interest rates and the negative consequences of central bank interventions in the allocation of resources.
Austrian economics views inflation as a monetary phenomenon caused by the expansion of the money supply. It emphasizes the distortions it introduces into the economy, the importance of sound money, and the subjective nature of value and price changes in response to inflation.
I believe that inflation primarily stems from an increase in the money supply within an economy, often caused by excessive money printing or credit expansion by central banks and governments. This monetary phenomenon erodes the real value of money over time. To safeguard against such erosion, I, advocate preserving wealth in the face of inflation. This can involve diversifying investments into assets historically known to hedge against inflation.
I share the concern regarding fiat currencies (those not backed by physical assets), as they can lose value due to inflationary pressures, making asset diversification a prudent strategy. Lastly, maintaining a long-term perspective and focusing on preserving wealth and financial security, rather than pursuing short-term gains, aligns with my investment philosophy.
It's essential to acknowledge that individual circumstances vary, and consulting with financial professionals is advisable when formulating strategies in the context of inflation and wealth preservation.
AAO Research