Inflation is a hot topic right now. The stock market swoon in January was largely blamed on inflation expectations. Others have called for an abandonment of Bonds due to inflation fears. But what is inflation? How does inflation impact your costs and investments?
Inflation is generally a measure of the change in a prices in a market. If you recall money is just a tool of measurement of underlying value. So inflation at it’s core is a change in how many goods your money can buy. As such on it’s most basic level inflation means items you buy cost more and your money does not go as far.
Inflation is a Major Concern for Those On A Fixed Income
Obviously rising costs are a big deal if you are on a fixed income since if your income does not raise with costs you can find yourself with less purchasing power then you thought you had. This is why people always recommend you have your funds invested in the market rather than sitting idle in cash. Each day you are not invested, and thus not growing your assets, is a day your overall worth has declined in real value during times of inflation.
What Causes Inflation?
This is the obvious impact of inflation, but what causes inflation. Inflation causes are typically separated into two categories, demand and cost based. To start let’s establish a general model (Aggregate Demand and Supply Model). Picture a supply curve representing all goods provided in an economy (Aggregate Supply). Now picture a demand curve representing all goods people actually want to buy in the economy (Aggregate Demand). The point where these two opposing sloped lines intersect defines the aggregate price of everything in the economy. Now let’s start by applying cost based inflation changes to this model.
Cost Based Inflation
If we look at the supply curve, it represents the cost per unit produced in the overall economy. In general in a static situation the more produced, the higher the price. However, this line is not static. It shifts left or right in relation to the change in the cost to supply goods in the economy. So imagine if a core natural resource that drives our economy, like oil, increased the cost of everything in the economy. Producers would eventually pass these added costs on to consumers. The ultimate result would, in the absence of any other changes or knock on impacts, make each unit sold in our economy more expensive to produce. It would in effect shift the supply curve to the left, by itself resulting in an increase in price (inflation).
Imagine the opposite, say a tax cut occurs. It reduces the cost of goods in the economy. All else equal and no knock on effects, this shifts the supply curve to the right resulting in a decrease in price (deflation). This reduces the cost of everything produced in the economy. If tax cuts and other areas only impacted the supply side they would be the end all of improving the economy.
Demand Based Inflation
This brings us to the demand side of inflation changes, the more complicated side. The other curve, aggregate demand, represents everything people will buy at a given price. In theory at a lower price they will buy more of something. Furthermore, the more demand for something, all other things being equal, the higher the cost as firms will maximize their profits based on demand. The problem is, like supply this curve is not a static line. It shifts to the left, decreasing prices, or shifts to the right, increasing prices in relation to events in the economy. It’s influenced by any number of things:
- The first one is expectations. If society expects a change in the economy then the demand curve will move as people react in relation to that expectation. They may buy less because they think a recession is coming, or they buy more thinking the good times will roll. This can move the demand line left or right. In essence there is a separate demand factor for the members of the economy around money. This demand can influence the demand for purchases.
- The second one is the amount of money people actually have, the money supply. The lending rates, paychecks, taxes and any number of other things influence how much of what is produced is demanded. More money can shift the demand curve to the right, because the more money available the more people are willing to pay for each individual unit. In the absence of other changes it can drive up price as people essentially compete to make a purchase.
- Finally, in some cases people will just not buy any more or reduce their desire to buy more. This could be due to the law of diminishing returns. Say I like oranges and will eat more if the price drops. I will continue to eat more for awhil,e but there comes a point where I will just not buy any more oranges. A line of diminishing returns will be hit. This decreased demand will potentially offset or decrease other changes in demand shifting the curve to the left.
The key to what the economy does in relation to these changes ultimately depends on how the public and producers react. If people buy more and the economy produces more than inflation will be minimal. If one of them goes out of balance inflation or deflation will occur. These curves are never static in practice, and so long as they move in tandem inflation is mostly in check. When one curve moves at a higher rate than the other is when you get inflation.
Inflation and Today
So to our current situation, we have a few major factors going on right now.
- The first is the tax cuts. This reduced the cost to produce and thus the supply curve shifted to the right, lowering costs of production to some degree. How much depends on how much the economy can produce in relation to the change in price. Can producers increase their production in step with the curve shift? Simultaneously this dumped money into the economy, increasing money supply. But did it increase the actual demand for goods or have we hit a point of diminishing returns? Also will the bid up in prices from more money circulating offset the decrease in production costs from the tax cuts? Finally how does everyone feel about the economy? All these things combined determine how the recent tax cuts will impact the economy. No human can give you a definitive answer on all these questions, which is why my tax impact post gave a less than firm response.
- But there is more. The labor force is also tight, ie. there are more jobs available then there are qualified applicants. So the price of labor is going up unless we have enough immigration or unemployment to offset the added jobs. So this is shifting the supply curve to the left, the opposite direction of the tax cuts. Which is stronger? Will the added labor force mean more demand for goods or just higher costs?
- Finally the government has been pumping money into the economy through other sources like QE2. Till now that money has been locked on banks balance sheets in the form of reserves. Will banks start lending out this money? If banks start loaning this out to the public at higher rates will it lead to more money supply then demanded goods?
What Will Happen Next With Inflation
It’s enough to make your head spin considering all the factors. Your guess is as good as anyone what really will happen next with inflation. The government tries to control it, though one can argue they only really do so by attempting to impact the populace’s expectations. I.E. the real power of the Fed is less about rates and instead about what you think their actions say about the future. This drives your demand for more items. Outside of that increased government spending can result in increased demand, but unfortunately the loans necessary to do so change the supply side as well. Taxes likewise drive two aspects in costs down and money supply up. Thus the expectation discussion is truly the only clean way to have an impact on only one side of the equation.
Fisher Effect, Why Does it All Matter?
So back to the question of why this all matters. There is a second reason inflation matters beyond those on a fixed income. It also matters to those who invest. Irving Fisher, an economist from around the great depression, came up with a concept called the Fisher Effect. It basically stated that the real interest rate equals the nominal interest rate minus inflation expectations. In this case nominal interest rate is the aggregate of all interest baring items in the economy including the bonds you buy, stocks, the loans you take, and anything else that pays interest. The real interest rate meanwhile is your actual increase in purchasing value. This is the amount I am being paid for taking the risk that the other party will not pay me back plus the earnings of the instrument. Finally inflation expectations are what we expect of future inflation in the economy.
Example of the Fisher Effect
So in a specific example if I took out a 4% loan from the bank, 4% would be my nominal rate. That nominal rate would be a factor of my real return, or risk driven return and earnings, plus the over all expectation of inflation in the economy. If I expected a higher amount of inflation in the economy, then my nominal rate should be higher assuming all other aspects of my investment are the same. This means expected increases in inflation drive the interest rates you receive on your investments. So if tomorrow the world expects inflation to be 2% higher all other things being equal, then I should receive 6 % on my loan if I purchased it tomorrow.
The ramification of increasing interest rates expectation meanwhile, means a decrease in the value of my 4% existing loan to the bank since now they can get a 6% loan. Or looking at it the other direction, the 4% bond the bank holds decreases in value. In the same way your bonds and other holdings will decrease in value in absence of other knock on effects. This is because the expected inflation is now expected to cut into your risk premium!
So in summary, you care about inflation because it can decrease the value of your investments and increase the cost of your purchases. They are always in flux, and the only thing you can be certain of is that people’s expectations play a major part in what happens next. There are ways to combat these changes, a post for another day perhaps.
Any questions about inflation? I realize this is a more technical post then I usually produce but hopefully you’ve found it interesting.