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What is inflation?
Inflation is the rise in prices over time and the decrease in purchasing power of money. The inflation rates for different countries and currencies vary.
For example, over the past 10 years, the dollar weakened only by 22.96%. In other words, $1 in 2011 is equivalent to $1.25 at the beginning of 2022. On average, the dollar inflation was 2.05% per annum, but it varied from year to year. In 2011, the inflation was 3.16%, and in January 2022, it reached 7.5% in annual terms.
It sometimes happens that prices fall while the purchasing power of money increases. In this case, it is called deflation. The Japanese economy has faced this in recent decades. If we look at the period from 2011, the average annual inflation in Japan was 0.56%, but in some years it was negative. In 2011, it was -0.27%, and in 2021, it was -0.02%.
Inflation is necessary for economic development, but of course, only if prices are rising moderately rather than at a galloping pace. For Russia, the optimal inflation rate is 4%, at least the Central Bank is guided by this figure. In the USA, the Federal Reserve aims for 2% inflation.
Thus, if inflation is considered a deliberately negative factor among the people, experts agree that moderate price growth is necessary for economic development. But it becomes a problem when inflation gets out of control and rises sharply, as is happening in Russia and the USA in 2021 and 2022.
What types of inflation exist
Inflation can be classified as follows:
- Deflation is negative inflation. This means that prices are not rising but instead decreasing. Deflation slows down the development of the economy. Consumers stop buying goods in hopes that they will become even cheaper, and companies therefore reduce production.
- Low inflation for the ruble is up to 6% per year, ideally around 4%. Such inflation allows the economy to develop comfortably for both consumers and entrepreneurs.
- Moderate inflation is from 6 to 10% per year. It is dangerous because it can get out of control and turn into runaway inflation, when prices rise by tens of percent per year. Such inflation creates instability in the market.
- Hyperinflation is when prices rise by hundreds or thousands of percent, in particularly severe cases people refuse money and switch to barter.
Hyperinflation. There are cases of rapid devaluation of money, usually during periods of severe crises and armed conflicts.
For instance, in 1992, the annual inflation rate in Russia reached 2500%, and the savings of many Russians devalued. In 1993, inflation amounted to 840%.
More recent examples of hyperinflation are Venezuela and Zimbabwe: in 2020, prices rose by 2355% and 557.2%, respectively. Moreover, for Zimbabwe, this is a chronic problem: in 2000, a mass exodus of the workforce led to the collapse of the country’s financial system.
To support spending on government projects, the government began actively printing Zimbabwean dollars. And money, like any other commodity, loses its value when in excess. This triggered the process of hyperinflation.
In November 2008, monthly inflation reached 79,600,000,000%, with prices doubling every 25 hours. This was just below the record set by Hungary in 1946, when peak monthly inflation reached 41,900,000,000,000,000%, and the highest denomination banknote was 100,000,000,000,000,000,000 – one hundred quintillion pengos.
The Zimbabwean government continued to release even more money, but with higher denominations. Banknotes with a face value of 100 trillion appeared, with an exchange rate of $30 in January 2009, $5 in 2011, and only 40 cents in 2015.
After the government refused the national currency and switched to the American dollar and the South African rand. In 2019, Zimbabwe reintroduced its own currency, but the country continues to struggle with high inflation rates.
What causes currency depreciation?
Here are the main factors of monetary erosion.
Growth in demand. The most common explanation of inflation is based on the principle of supply and demand.
On the free market, if demand for a particular product exceeds supply, its price tends to rise. If, on the contrary, supply exceeds demand, prices decrease. In other words, when there is an oversupply of goods on the market, they lose value.
This principle also applies to money. If there is too much money in circulation, both cash and credit, their value goes down. The central banks of countries regulate the amount of money in the system.
Another explanation for the cause of inflation is the increase in the cost of raw materials and labor. For example, oil affects the pricing of goods and services, as the transportation component is included in the cost of the majority of them.
But most economists agree that it is the demand for the final product that triggers the increase in commodity prices and, as a result, the final product.
Suppose there is an increase in demand for bread. The baker depletes his supply of flour and if demand for his product continues to rise, he will purchase more flour from his supplier. The supplier, in turn, will buy more wheat from the farmer.
Let’s say other bakers are also experiencing increased demand for bread. As a result, flour suppliers will receive more orders. They will start offering the farmer more money for his wheat, which will lead to an increase in prices for wheat, flour, and bread.
Thus, although it may seem that a higher cost of raw materials is responsible for the increase in the price of the final product, in reality, it is the collective demand for the final product that has caused the price increase.
Changes in relative prices of individual products do not mean that inflation is progressing. It is usually defined as a gradual increase in the overall level of prices for all goods and services.
Restriction of supply. The global economy is currently facing disruptions in supply chains, which creates a shortage in conditions of increased demand.
Restrictions on supply can also be artificial. For example, by regulating the level of oil production, the OPEC+ cartel can influence its quotes.
Deficit can also occur due to natural disasters, military conflicts, or crop failure.
Devaluation of the national currency. When the exchange rate of foreign currencies rises, imported goods automatically become more expensive. This factor serves as one of the drivers of inflation in Russia. As soon as the ruble weakens, foreign goods and Russian products with import components automatically increase in price.
On the other hand, the central bank cannot strengthen the national currency too much either. In this case, imported goods will become cheaper, flood the market and suppress local production.
How is inflation measured?
In the USA, the Bureau of Labor Statistics is responsible for calculating inflation. The result of their calculations is expressed in the Consumer Price Index – CPI.
The basket of the index includes over 300 consumer goods or services: food, housing, clothing, transportation, medical care, leisure, education, communication, and so on. These are eight categories, as shown below.
CPI composition for December 2020
| Subcategory | Weight |
|---|---|
| Food and beverages | 15.157% |
| Housing | 42.385% |
| Clothing | 2.663% |
| Transportation | 15.738% |
| Medical care | 8.87% |
| Recreation | 5.797% |
| Education and communication | 6.81% |
| Other goods and services | 3.159% |
The percentage increase in CPI is usually taken as dollar inflation, but this is not the only indicator. Often, Core Inflation is taken – basic inflation, that is, CPI minus volatile categories of goods. There is also the Producer Price Index – PPI, which measures inflation in the early stages of the production cycle, and the Employment Cost Index – the index of labor costs in the labor market.
But blindly trusting official inflation data is not worth it. They may not reflect the whole picture and often lag behind the real increase in prices. In addition, the structure of the consumer price index is heterogeneous: different goods and services are distributed in different proportions and grow at different rates.
As a rule, high-quality goods and skilled services that are difficult to automate or replace increase in price faster than the CPI. For example, this applies to medical services.
Also, each person or family has their own consumer basket in fact due to the different ratio of regularly used goods and services. In practice, it often becomes more expensive faster than CPI, and people feel it in their wallets. The tool for calculating personal inflation is the website of the Federal Reserve Bank of Atlanta.
What harm does inflation cause?
Inflation in general harms people and the economy.
Investments lose value, real income decreases. For example, you held money on a bank deposit at an annual rate of 5% with an inflation rate of 4%. The real income of these investments, that is, net of inflation, was about 1% annually.
If inflation rises to 6% and the key rate is not raised, the yield on risk-free instruments such as deposits and government bonds will not be able to cover the inflationary erosion of money.
The same applies to fixed income such as social benefits or rental income. As inflation grows, their size will decrease in real terms, and it does not always rise in line with inflation. For example, the cost of renting an apartment may not increase, as there is an oversupply of properties in the real estate segment.
Creditors are raising interest rates. If a bank expects inflation to rise or if the regulator increases the key rate, loans for citizens and businesses will become more expensive. Debts will be harder to service.
It’s difficult for businesses to plan for the future. When the level of inflation is unknown, it’s hard for producers and retailers to determine the future cost of materials and labor. This hinders investment and economic growth.
To curb inflation, it is necessary to reduce the gap between the money supply and the commodity supply in the economy. Various measures can be used for this: price, currency, and credit regulation.
The standard way to combat high inflation is to raise the key rate. This is the interest rate at which the central bank provides loans to commercial banks. They, in turn, raise the interest rate on deposits and loans for their clients. So what? How will raising the Central Bank’s rate affect the tax on interest on deposits in 2022?
So, in December 2014, the Central Bank increased the rate from 10.5% to 17% at once. This allowed to restrain the rise in prices and stabilize the ruble exchange rate. Currently, the Central Bank is acting similarly: if the rate was 4.5% per annum in March 2021, then by mid-February 2022 it reached 9.5%. And on February 28, 2022, the Central Bank raised the rate to a record 20%.
What to do as an investor
Even when inflation is moderate, over the horizon of many years it can significantly erode capital. Therefore, an investor needs his assets to generate a return at least equal to inflation. In other words, their real return should be positive.
Also, to protect against the devaluation of the national currency, it is recommended to keep at least 50% of the portfolio in assets expressed in strong currencies: dollars, euros, yen, Swiss francs. In this case, no matter where the currency pair moves, the capital will retain its purchasing power.
In conditions of progressive inflation, some types of assets can perform well.
Physical assets such as real estate, cars, and luxury items. For example, in the United States, the prices of used cars have increased by 25% in a year, thereby fueling overall inflation.
A specific real estate property can appreciate faster than inflation devalues money or it can appreciate slower – it depends on the type of property, its location, and other factors. The rent or lease payment also does not always increase in proportion to inflation.
Bonds with floating coupons. In the US, these are TIPS – treasury bonds with inflation protection. When inflation rises, coupon payments on such bonds will grow, and the bonds themselves will not decrease in price.
Commodities are raw materials such as oil, gas, aluminum, and wheat. It is possible to invest in commodities on Russian exchanges, for example, through shares of raw materials and agricultural companies.
Experienced investors and traders can use futures and options on commodities, but these are more complex and risky instruments.
Gold often increases in price with inflation and also during a stock market downturn, but it is not guaranteed. In addition, it is a volatile instrument in itself and does not provide any passive income. You can also invest in gold by buying stocks of companies that mine it. In this case, you will be able to receive dividends, but stocks also have their own risks. For those who prefer physical metal, investment coins can be a good choice.
The advantage of gold is that it has a weak correlation with stocks and bonds, making it a good diversifier. Adding it to an investment portfolio usually reduces its volatility and improves the ratio of return to risk.
Stocks of companies from protective sectors. These include telecommunications, utility companies, producers and sellers of essential goods such as food, hygiene products, and medicine. Prices for products of such companies will rise along with general inflation.
But in the case of communal enterprises, one needs to be careful: usually such companies have large debts on their balance sheet, and the business margin is weak. If interest rates increase, their debt service costs will increase.
The financial sector may also benefit from the increase in rates, as the interest rates on loans issued will be higher.
As for the real estate sector, the data on its protective nature during inflation is contradictory, at least in the US. NAREIT claims that the growth of dividends of REIT funds has outpaced the growth of consumer prices in the US over the last 20 years, and Vanguard calculated that over the last 50 years, REIT has performed worse than gold, commodities, and inflation-linked bonds in this sense.
Summary
- Inflation is the increase in prices and the devaluation of money. Moderate inflation is necessary for a healthy economic development.
- Central banks strive to keep inflation under control and target its level to an optimal value: 4% for Russia and 2% for the United States. To achieve this, they use various measures: price, commodity, currency and credit regulation. Over the past year, the Russian Central Bank has raised the key rate from 4.25 to 20% annually to contain price growth.
- If inflation is progressing, historically it is best to hold money in tangible assets, gold, and commodities. TIPS bonds also provide inflation protection, but currently their real yield is negative.
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