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All You Need To Know About Inflation | Yosef Stein

As the US economy continues to grow in the wake of the pandemic-induced recession, one sinister threat looms menacingly over the otherwise-impressive economic recovery. The increasing rate of consumer inflation, and the specter of even higher inflation yet to come, has economists sounding the alarm and hearkening back to the 1970s as a cautionary tale of inflation run amok. This article is about the mechanics of inflation, which admittedly is a bit of a dry topic – albeit one that is important for everyone to understand, especially at the present time. I have done my best to break the analysis down into digestible, bite-sized pieces by exploring the issue in a Q&A-style format.

What is inflation?

Inflation refers to the decrease in the purchasing power of money – or, analyzed from the other side of the equation, an increase in the prices of goods and services. If money is worth less now than it was before, inflation has occurred. Since each dollar loses value in an inflationary environment, the amount of dollars needed to purchase products and services rises. This is why consumers typically experience inflation in the form of price increases.

It is also possible for money to increase – rather than decrease – in value. This is called deflation.  However, for reasons that we will explore later, policymakers work hard to ensure that no deflation occurs in modern economies.

What causes inflation?

The market value of money, like the value of any asset in a capitalist system, is affected by two forces: supply and demand. The greater the supply of dollars, the less each dollar is individually worth (everything else being equal). The greater the demand for dollars, the more each dollar is individually worth. So inflation occurs when the demand for dollars fails to keep upwith the supply. Deflation would occur if the demand for dollars outpaced the supply.

Needless to say, this is merely a surface-level answer to the question. To truly get to the bottom of what causes inflation, we would need to consider the myriad factors that influence supply and demand for currency. Moreover, supply and demand often directly affect one another. For example, increased demand for a currency generally results in increased supply, as policymakers print more money to stave off deflationary pressures. Conversely, when the supply of a currency rises, demand often falls along with confidence in the currency’s stability.

Hyperinflation, which has devastated unfortunate economies throughout the world, often begins with an increase in thesupply of a currency, which causes a loss of faith in the currency by the public, resulting in a precipitous fall in demand for the currency, which in turn fosters expectations of continued loss of value moving forward. When the general public loses faith in a currency, the demand hit inevitably sends the prices of goods and services soaring. In November 2008, at the height of its hyperinflation crisis, Zimbabwe saw consumer prices double every 24 hours. As recently as January 2019, the Venezuelan bolivar underwent such dramatic inflation that prices were doubling a couple of times per week.

While both supply and demand are critical to identifying the causes of inflation, this article focuses more on the supply side of the equation than the demand side. This is because (at least in the case of a relatively stable currency) demand for money is generally rather fixed, while supply is more prone to fluctuation and manipulation. Recent fluctuations in the value of the US dollar have been driven far more by supply changes than demand changes.

Is US inflation currently high?

Yes. The most recently available Consumer Price Index (CPI) figures have year-over-year consumer inflation pegged at 6.2% – far above its historical average. Real inflation is presumably running significantly hotter than these government figures indicate, as the CPI has failed to track actual inflation for decades. Anyone who purchases groceries on a weekly basis can attest that consumer prices have risen significantly more than 6.2% in the past year. Even taking the 6.2% figure at face value,however, the inflation rate is more than double the Federal Reserve (Fed)’s official annual inflation target of 2-3%.

Wait … The Federal Reserve has an official inflation target? Why do policymakers want inflation?

Do you want the official reason, or the real reason? Let’s start with the official reason. Officially, central bankers imposeinflation upon us year after year because without inflation, people would not be incentivized to spend their money and thus stimulate the economy. If people’s savings were allowed to rise in value year-over-year, chas v’shalom, they might determine that it’s smarter to save their money than to spend it. The Fed obviously knows better than you what you should do with your money, and therefore maintains a steady rate of inflation in order to chip away at the value of your dollars, disincentivizing saving and encouraging spending.

The official reason for inflation sounds bad enough. What’s the real reason?

The US monetary system is debt-based, a fact which many Americans are unfortunately not aware of. This means that virtually every dollar that is minted enters the economy in the form of debt. When someone takes out a bank loan to purchase a home or start a business, that money is not sourced from someone else’s deposits with the bank. Rather, it is new money created by the bank on the spot – subject to a 10% reserverequirement, which allows banks to print $90 for every $10 deposited. Similarly, the Federal Reserve prints money directly and injects it into the economy through a process called quantitative easing – buying government and corporate bonds (i.e. debt) in the open market.

One of the many flaws with a debt-based monetary system is that of sustainability. Since virtually all money enters the economy as debt, and debt generally needs to be paid back with interest, where is the interest money supposed to come from? Obviously, from new debt. This sustainability problem necessitates an ever-increasing monetary supply, so that the old debts can be paid back with interest out of the new, larger pool of money. An ever-increasing monetary supply ensures ever-persistent inflation. (As an aside, European central banks have recently been experimenting with a different “solution” to this sustainability problem – negative interest rates.)

To truly grasp just how nefarious the Fed’s inflationary motives are, however, we must examine who benefits most from inflation.

Who benefits most from inflation?

Debtors. Inflation benefits those who owe money, at the expense of their creditors. Once you understand this fact, you will never view inflation the same way again. Take the US federal government, the biggest debtor entity on Earth with a debt load of $29 trillion. If the federal debt hypothetically remains steady at $29 trillion for the next year (which it obviously will not) but inflation chips 6.2% off the value of the US dollar, the value of the debt (in today’s dollars) will fall to $27.2 trillion – making for a more manageable debt load. If inflation remains steady at 6.2% the following year, the real value of the debt will fallfurther to $25.5 trillion. As inflation continues to chip away at the value of the dollar year after year, which has long been and will long continue to be the case, government borrowingbecomes a lot more sustainable over the long term.

Not to be outdone, US corporations have been jumping on the debt-binge bandwagon as well. Nonfinancial corporate debt has recently ballooned to over $11 trillion according to Fed figures, as corporations have taken advantage of artificially low interest rates to pile on debt-based liquidity – which is exactly what the Fed wants. Compare the >$40 trillion in government and corporate debt to US consumers’ outstanding debt balance of $4.5 trillion (excluding home mortgages), and you can immediately see who benefits most from inflation.

Whom does inflation hurt the most?

Savers and wage-earners. Inflation eats away at the value of cash savings, reduces the value of wage earnings, deprives bond investors of the full yield to which they are entitled, and diminishes real stock returns. While in theory one might expect wages and yields to rise to reflect the inflationary input, and though stocks are often considered a long-term inflationary hedge, over the short term wages and investment returns rarely thrive in high-inflation environments. Thus, it becomes a struggle for savers to so much as preserve the value of their capital in the face of inflation – let alone grow it. It likewise becomes an uphill battle for wage-earners to so much as preserve their standard of living – let alone enhance it.

Is it Biden’s fault?

Yes and no. President Biden’s administration has certainly advanced its fair share of inflationary policies, such as the $1.9 trillion American Rescue Plan and $1 trillion infrastructure bill. Moreover, Biden just announced that he is nominating Fed Chairman Jay Powell – the prodigal propagator of American inflation – to a second term as Chairman of the Federal Reserve. If Powell’s second term is anything like his first, inflationary monetary policy will continue to be par for the course.

That said, President Trump borrowed and spent similar sums during his term in office, and it would be silly to believe that the effects of his policies are not also contributing to the current inflationary pressure. In particular, Trump’s inflationary excesses included the $2.2 trillion CARES Act, the subsequent $900 billion stimulus bill, significant tax cuts not offset by any spending cuts, record deficits, and spending hikes on the military and discretionary social programs. Oh, and Trump originally nominated Jay Powell and also publicly leaned on him to facilitate easy-money (i.e. inflationary) policies such as low interest rates.

Ultimately, it would be overly simplistic to assign all the blame for high inflation to Biden, Trump, Powell, or any other individual. Many factors, both in and out of human control, contribute to the value of money at any given time. That said,each of the aforementioned officials certainly bears some of the blame for the inflationary environment in which America finds itself today.

What can individuals do to protect themselves?

As previously mentioned, savers tend to be hit hardest by inflation. Savers can mitigate their inflationary risk by sticking to long-term investments, which tend to be more inflation-resistant. For example, stocks and real estate have historically tended to hedge well against inflation over long holding periods. Similarly, solid assets such as precious metals (or even consumer goods, for that matter) tend to hold their value in the face of inflation. Cryptocurrencies may be the inflation hedge of choice for the brave of heart, while the most conservative savers may wish to convert their cash into inflation-hedged bonds such as Treasury Inflation-Protected Securities (TIPS). Everyone’s financial situation is unique, of course, and no universal recommendations or advice can be given. Personal finance questions can only be properly considered on an individual basis. That said, it is worthwhile for everyone to understand how inflation works, and the types of assets that tend to resist inflation better than others.

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There are 11 Comments to "All You Need To Know About Inflation | Yosef Stein"

  • MG says:

    Who is the US debt owed to?

  • Jackson yid says:

    A great article. Thank you!

  • Ploni Almoni says:

    All I have to say is Lets go Brandon.

  • The Gonzalez Factor says:

    Infusing the economy with fiat currency is not debt-based; it is the use of fiat currency being pumped into the economy. Under the gold standard economy, asset-backed dollars were in circulation wherein the Fed could not pump the economy with dollars indiscriminately. While that was useful for inflation, there was no flexibility within the system, which led the US going of the gold standard in 1972.

    Fiat currency, when managed correctly, works better than an asset-backed currency. Part of managing fiat currency is inflation control. Inflation thrives when there are low interest rates and money is circulating within the economy. The Fed generally uses interest rates to manage inflation, which is controversial based on Austrian Business Cycle theory (a bit of a different discussion).

    Inflation happens as more currency is generated and more money flows through the economy. Ways to manage inflation include using 2 parallel currencies (see Chile with the Peso and UT) and indexing (Israeli currency management in the 60s and 70s).

    Anytime a government devalues its currency can lead to investor damage. Devaluing a currency is effective for increasing exports because it makes a host country’s output cheaper on the world market. In effect, this strategy encourages more domestic production and export, which is what Trump wanted to do. At the same time, though, investors in dollar-denominated investments will lose out because the investment returns do not match the inflationary output.

    Note that not all cryptocurrencies are inflation-hedged. Bitcoin and Etheruim are because of their finite nature; Dogecoin, in contrast, are not finite and are susceptible to inflation.

    There is more to say. Good stuff.

    • Avi says:

      wow you are clueless, going off the gold standard gave us flexibility! yea it did just like when i live off my credit cards it gives me lots of flexibility. the only reason we went off the gold standard is so the politicians and big business could line their pockets, inflation = theft they puposly make our hard earned money worth less it has zero benefit to the american people only detrimental

  • Avi says:

    It would be very wise if you have extra cash to buy physical silver 1oz 10oz or 100oz bars it is not effected by inflation on the contrary when the money is worthless precious metals go up

  • Gold Man says:

    Just commenting that this was well written and spot-on.

  • economist says:

    i would not call crypto an inflation hedge. maybe its not negatively affected with inflation but it is not going to go up, like stocks and real estate will.

  • economist says:

    fyi. the cpi doesnt track inflation because it does not take all categories into account.

  • reader says:

    Wow! Clear and simplified explanation of a complicated concept! Thank you!

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