What's Happening With Inflation?
Inflation is on everyone’s lips – but what exactly is it? Who makes the decisions when it comes to the economy? Is there a way to ‘shockproof’ your finances?
If you’ve found yourself worried about the cost of living crisis, and don’t understand why inflation is happening right now and whether you can help alleviate the pain of rising costs – give this episode a listen!
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You can listen (11 min) and subscribe here:
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what is inflation?
“Inflation is very difficult to forecast since there is a psychological component embedded to it. It’s not just about supply and demand, but also about expectations”
Inflation is a measure of how much the prices of goods and services increase over time. It is one of the most relevant economic measures for consumers as it affects their buying power and has an impact on everything from fuel prices to mortgages, as well as things like the price of train tickets and the cost of shopping.
National central banks sometimes have the sole objective of keeping inflation under control, like the European Central Bank, while others, like the Bank of England or the Federal Reserve have a dual mandate of inflation and unemployment. In order to control inflation, central banks can change the financial conditions — this is called a monetary policy — by increasing or decreasing interest rates or increasing and decreasing the amount of money in the financial system.
This might seem complicated, but it's in fact very simple. For example, if mortgage rates are very high, let's say 15%, you will not be able to buy a new house since you can afford a mortgage. As the amount of buyers shrinks, sellers need to lower the prices in order to attract buyers, which eventually cools the housing market until we find a new equilibrium. The opposite is also true — as we have recently seen throughout the developed world, where house prices are hovering at an all-time high thanks to low interest rates.
Quantitative easing is when you increase the amount of money in the system by printing new bills. Therefore, as more money is chasing the same amount of goods, prices tend to rise in order to balance the supply and demand. Quantitative easing is used when you want to stimulate the economy, and quantitative tightening is used when you want to slow down the economy.
the history
When we look back at history, you could see inflation rising during and after major conflicts. This can be explained mainly by a couple of factors: one, large government borrowing to fund wars and two, as the war unfolds, supply chains are disrupted.
As the supply of goods falls, prices need to adjust in order to meet the same demand. History is full of examples of such a dynamic: World War I, World War II and the Vietnam War, to name a few.
While inflation can sometimes be a difficult concept to comprehend, I like to think about it this way: over time, your money can buy you less and less stuff until, eventually, your money can't buy you anything. Indeed, if we push it to an extreme, inflation will purely and simply destroy money as people lose confidence in its value. If I don't believe that the ten pound you give me today will be worth ten pound tomorrow, why should I accept it?
This might seem too extreme, but it's what happened to Germany after World War II. Later in the century, Argentina saw its prices explode so much that people shopping in supermarkets found that between the time they entered the shop and reached the till, prices had moved so much that they needed to adjust their purchases in order to either get rid of extra cash in their plastic bag or get less food for their money.
Too much inflation or negative inflation, also called deflation, has irreversible consequences, especially in terms of confidence. Our economic system is built on confidence. Confidence that you can walk into a shop, and they will accept your money, confidence that your bank will give you cash when you insert your debit card in an ATM.
protecting your money
Our central banks have been particularly bad at forecasting inflation. While the Federal Reserve thought inflation to be transitory, they had to admit that they had made a mistake, since inflation was more entrenched than they thought. Therefore, they had to increase rates much higher and faster than expected in order to fight inflation.
A loss of confidence in the central bank's ability to fight inflation will undermine the entire system. That means your savings, your home and your work become worthless. When things get bad, they can get really bad and people run out of money.
In a nutshell, we are going back to basic essential needs while the rest remains frivolous. Inflation is very difficult to forecast since there is a psychological component embedded to it. It's not just about supply and demand, but also about expectations. If you think the price of wheat, pasta or bread is going to skyrocket, you're going to buy more pasta today, since you think prices tomorrow will be higher.
Unfortunately, prices will keep increasing as more and more people think like you until something breaks or people start thinking price will increase, or maybe even prices may decrease and therefore will delay their consumption. You clearly see here why it is so important for the central bank to keep this inflation narrative under control.
If you want to protect your money, it’s important you tighten any loose ends, review all your credit and have a clear plan on how you will repay any loans.
Review your spending habits. What would you do if energy prices and full prices were to double, quadruple, or increase tenfold? Remember, it has happened in the past, so it's time to make a plan.
You're should also join our next market update on Thursday the 7 July at 12.30 when we're going to look at what's happening in the economy and the stock market.
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