So what exactly is inflation?

Well, the definition can vary a lot, depending on what you’re reading or where you get your information. Here is one we like.

Inflation is an artificial increase in the money supply that leads to higher prices for goods and services.  

The “higher prices” part is probably no surprise. What people often miss is that the higher prices are just a symptom of an underlying problem. To understand inflation, we need to look at what causes it.

Inflation and the Money Supply

What is money? At the simplest level, money is an economy’s most liquid asset, which serves as a medium of exchange.

If we didn’t have money, we would have to barter for whatever we want.

For example, if you were a cattle rancher who wants eggs, you would have to exchange steaks with someone who has egg-laying chickens to get eggs in return. Likewise, when the chicken farmer wants a bottle of wine, he would have to look for a vineyard owner who likes scrambled eggs.

Everything works much better when we have some commonly recognized medium of exchange. We call that item, money. Most civilizations settled on precious metals as money.

Unfortunately, societies also figured out ways to manipulate the money supply. That’s where we get inflation.

Coins, Paper Money and Inflation

Somewhere along the way, someone hit upon the idea of coining money. Instead of taking gold to the neighborhood bazaar—and possibly losing it or being robbed—savvy shoppers could deposit their gold with someone who would keep it safe. This individual would give out a receipt that other people would recognize and accept as “good as gold.”

Kings and bankers realized they could issue receipts representing more than the total amount of gold people had deposited. It was a great ruse because the chance that everyone would simultaneously demand their gold was very low.

Because more coins and bills were circulated, people mistakenly thought they had more money than they really did, so they spent more freely. The amount of gold in the national vault hadn’t changed, though, so each coin or bill lost a little bit of its value.

This is inflation. Prices may look higher, but what really happened is that money lost part of its value. Consequently, additional cash is needed to buy the same amount of product. The “real” price didn’t change. What changed was the price of money.  

Modern governments and bankers have refined inflation into an art.  They manipulate the money supply electronically, and often secretly. They’ve convinced themselves—and most of us—that a little inflation is actually good.

It’s true that inflation’s initial effect can look benign and even helpful… but looks can be deceiving.

Inflation and Prices

Let’s say that once a year, you buy a jar of honey.

When you last bought your annual honey supply in April 2011, the total cost was $5.00. You replenish your coffers every April when your local beekeeper gets his new supply.

It’s now April 2012, and you head to the market to restock your honey supply. When you arrive, you notice that the price has gone up $0.10 to $5.10.

Although you can probably afford this small increase, you ask your beekeeper why the price went up. It seems odd, as the bees work on a natural cycle, so the costs associated with creating the honey—maintaining the hives, packaging the honey, etc.—should stay relatively constant.

Your beekeeper explains that a bear broke into his apiary and mangled the fence that surrounds the hives. Thankfully, the beekeeper shooed the bear off before it could eat any of the honeycombs, but he still had to replace his fence. In order to cover these costs, maintain his normal profit margin, and keep his business afloat, the beekeeper raised the price of his honey by 2%.

Economists call this type of inflation—where a producer’s input costs rise—cost-push inflation. It arises when wages, taxes, raw materials, or import costs increase.

In this case, the beekeeper’s operating costs rose because of the bear’s vandalism, which incentivized him to inflate his prices to cover these new costs. Rather than absorb the fence repair cost, which could potentially cause him to go out of business, he pushed the costs onto his customers.

There’s a missing piece, though. Why did the bear choose to invade this apiary at this particular time? Nature is good at keeping the number of bears in balance. They never attacked here before. Did something change?

Indeed it did. The bear’s usual habit is to raid several small amateur beekeepers in the next valley. Tired of this, they decided to relocate this year, so the hungry bear raided the local apiary instead.

So what was the impact on the total honey supply? The local beekeeper’s supply declined because of the ursine thievery—but the other beekeepers produced more honey because they left the bear’s territory. The net impact on the honey market is actually zero.

It’s now April 2013, and—you guessed it—time to buy more honey.

Much to your surprise, prices have gone up again!

In fact, honey is up another $0.10 to $5.20.

Out of curiosity, you once again ask your beekeeper why prices went up. Did another bear attack the apiary?

Nope. This time, the beekeeper explains, his honey received a “best honey in the state” award. As a result, people sent a flood of orders to his new website, but he only produced the same amount of honey as in years past.

In other words, demand for the beekeeper’s honey was rising faster than his supply of honey, so he decided to raise prices to compensate for this new dynamic.

Economists call this demand-pull inflation. It occurs when too much money chases too few goods.

Here again, there’s an interesting dynamic. The people now flocking to the local, award-winning beekeeper also stopped buying honey from their previous suppliers. Those beekeepers reduced their prices to keep customers from leaving, offsetting your beekeeper’s price hike.

The price changes seen in these examples are strictly local events. Aggregate honey demand didn’t change, nor did the average price of honey. True “inflation” happens when prices rise in concert across an entire economy. 

Calculating Inflation

One reason people don’t understand inflation is that the government describes it with price data. When people talk about inflation, they usually cite the year-over-year percent change in the prices of a basket of goods set by the Bureau of Labor Statistics (BLS).

Every month, the BLS records prices all over the US. From this huge data set—which includes everything from transportation, to food, to medical care—they calculate the consumer price index (CPI).

The CPI tries to measure changes in the general price level of consumer goods and services. Most people use “CPI” and “inflation” interchangeably. That isn’t quite right, but it’s close enough for casual use.

For example, the CPI reading for February 2014 was 234.78, while in February 2013 it was 232.16. From this data, we can see that prices rose 1.13% [(234.78 – 232.16) ÷ 232.16 = 1.13] from February 2013 to February 2014.

Calculating CPI is an ever-evolving process. In fact, since 1980, BLS changed its methodology three times.

The first major change came in the way that housing prices fit into the CPI.

For most people, housing is one their biggest—if not the biggest—expense. We also know that housing prices can be volatile, as many Americans saw firsthand with the 2000s-era housing boom… and bust.

To reduce the volatility in housing prices, in 1983 the BLS began using “owner’s equivalent rent” (OER) instead of housing prices. In short, OER is the amount of rent a homeowner would pay for an equivalent rental property.

Since housing is a big part of the basket used to calculate CPI (the latest reading had a 42% weighting), using OER helps reduce volatility in the inflation rate.

As we can see from the following graph, it seems to have worked. Notice the red line had much smaller swings after 1983.

The next major change to the CPI came in 1998, when the BLS decided to incorporate “hedonics” into their equation. If you’ve never heard of hedonics, here is an example.

Let’s say you own a big, clunky, desktop computer. Everyone you know has upgraded to either a laptop or tablet at this point, but you love your old desktop, even if it’s still running Windows 95 and can’t access the Internet.

One day you turn on your computer and accidentally spill a glass of water on the motherboard, sending sparks everywhere and rendering your beloved computer worthless.

The next day you go to buy a new computer. You prefer one like your old desktop, but you notice there are only high-end desktop computers, laptops, or tablets for sale. Replacing the simple computer you bought for $300 over 20 years ago will now cost $1,000.

According to the BLS, this is not inflation. Instead, the BLS calculates an adjusted price of the original computer ($300) that includes quality enhancements (say, an additional $1,200), so the total calculated price, or value placed on the new computer, would be $1,500.

Just as in the example above, the price of the improved product as calculated by the BLS ($1,500) is higher than the retail price you’re paying ($1,000). Therefore, according to the BLS, the price went down because you’re getting more for your money.

That’s hedonics at work.

Another significant change to the CPI calculation came in 1999 when BLS factored product substitutions into the index.

Product substitution simply means that as prices go up, consumers will substitute an alternative for the originally desired product.

For example, let’s say you and your family love steak. However, a train carrying a large supply of steak derails, causing the steak supplies to drop, and subsequently sending the price of steak up. Although your family really loves steak, you can’t afford it at these elevated prices, so you buy hamburger instead.

The BLS would reflect this change in the CPI equation by removing steak and replacing it with hamburger. Even if the hamburger meat now costs what steak did before the increase, the index would show no change in inflation.

Costs of inflation

Inflation can affect people in different ways. Whether it affects you positively or negatively has to do with expectations.

For example, let’s say the Federal Reserve decides to increase the money supply in order to spur US economic growth. For the months leading up to this announcement, the Federal Reserve Open Market Committee (FOMC) would have been deliberating whether economic conditions were suitable for an increase in the money supply. These deliberations, also known as the FOMC minutes, are released the following month, so everyone can be familiar with the Federal Reserve’s thinking.

This process gives individuals and corporations time to assess inflation expectations, so the actual announcement is usually not a surprise. Banks will have had time to adjust their lending rates to reflect higher inflation, while workers would be able to negotiate automatic wage hikes in anticipation of rising prices and falling purchasing power.

The real problems arise when the economy experiences unexpected inflation that catches corporations and individuals off guard. This reduces spending and investment, which hurts long-run economic output. Retirees and others living on fixed incomes are disproportionately hurt because their fixed incomes lose purchasing power, thus lowering their standards of living.

An Extreme Case: Hyperinflation

When talking about unexpected inflation, we have to mention hyperinflation.

Hyperinflation is extreme or excessive inflation that rapidly erodes the real value of a local currency.

Hyperinflation typically occurs when there is a significant increase in the money supply with little to no change in gross domestic product. This imbalance causes prices to rise (i.e. too much money chasing too few goods) on a grand scale, thus causing the currency to lose most, if not all, of its purchasing power.

One of the most famous examples of hyperinflation comes from post-World War I Germany. Although the German hyperinflation scenario often conjures up images of people using papiermark (the German currency at the time) as firewood to heat their homes, the events leading up to the hyperinflation were quite rational.

It all started when the Allied powers agreed that Germany should pay reparations for the First World War, also known as the “London ultimatum.”

Prior to the war, Germany had suspended its currency’s convertibility into gold—funding their entire war effort through borrowing. This made the papiermark exchange rate fall from 4.2 marks per US dollar pre-WWI to 90 marks in 1921.

After Germany lost the war, the Allied powers sent troops to German industrial cities to claim their raw materials, such as coal, timber, and grains. This action completely obliterated Germany’s productive capacity and paved the way for an inevitable economic crisis.

Although this devaluation and sacking of German industrial hubs hurt the value of the mark, what really tipped the scales was when the Allies demanded that Germany pay annual reparations of $2 billion goldmarks plus 26% of German exports. This created a massive and unsustainable debt bubble. The country’s weakened industrial position made it even worse.

When Germany made the first payment in June 1921, the papiermark was worth only 330 marks for every US dollar. However, Germany had to pay reparations in hard currency—not the depreciating papiermark—so Berlin began printing marks in order to buy foreign currency, which they in turn used to pay reparations.

As Germany continued to print (with no additional goods to back their currency) the amount of money in circulation diverged from the physical economy. Inflation ran out of control. By November 1923, the exchange rate between the German mark and the US dollar was 4,210,500,000,000-to-1.

The cost of living for the average German citizen rose sharply in this period. By some estimates, prices increased by a factor of 20 billion, doubling every 28 hours. People would get their weekly pay and spend the money immediately before it was useless.

This exacerbated the problem, as more people trying to spend nearly worthless money on a finite supply of goods only increased the inflation rate.

Although the world learned many lessons about dealing with post-war economies and hyperinflation, nothing prevents such extreme inflation from happening again. Since 1923, we’ve seen dozens of different cases of hyperinflation, most notably in Zimbabwe.

Dangers of Deflation

At its most basic level, deflation is the exact opposite of inflation.

Deflation is an artificial decrease in the money supply that leads to lower prices for goods and services.

In almost all cases (save cases of persistently high inflation and hyperinflation), deflation is much more destructive than inflation.

Deflation can stem from many factors but usually comes from decreased bank-lending activity. Banks tighten their loan standards when they perceive higher default risks in the economy. The reduced “multiplier” effect means less money is in circulation. Prices begin to fall, or remain steady, when they might otherwise go up.

Economists call this “deleveraging,” and it can be a painful process for debtors. One of the prices that falls is labor. If income falls while loan payments stay fixed, a high debt load can become unbearable.

Thinking about it from an individual standpoint, the problems with deflation are self-evident.

For example, let’s say you’ve been saving money to buy a car. You’ve saved $15,000—just enough to buy that new set of wheels you want.

Then, negative economic news starts to roll in, and the economy suddenly falls into a recession. Because of the broad economic uncertainty, you decide to keep riding your bike and save your cash.

Although this seems like a completely rational thing to do, the result can be dreadful when it happens on a mass scale.

Let’s apply that same example to a business, which—as many people often forget—runs on the same economic rationale as the individual.

Let’s say that a business was going to invest in a new factory but decided to wait because of the economic downturn. These spending reductions, when done on a mass scale, mean fewer people are employed (i.e. to build and maintain the new factory). This leads to less overall spending since consumers have less money to spend, which then leads to lower profits for businesses. As a result, businesses lose the incentive to invest because of perceived lower demand.

We call this a deflationary spiral, and it is one of the most destructive forces in a normally functioning economy.

Central banks hate deflation because it is very hard to control.  They can try to spur inflation by creating more money. This helps only if the money goes into productive uses… which is rarely the case in practice.

The only real answer to deflation is time. Excesses will work out of the system eventually.

Inflation-Proofing Your Portfolio

Inflation—especially very high inflation—can eat into your purchasing power, making every dollar you’ve saved worth even less than it was before.

There are a few ways to protect your portfolio against inflation. You may have already done some of these, but factoring all of them into your portfolio is better.

First things first: let’s talk about stocks.

There’s a misconception that inflation is somehow bad for stocks. This couldn’t be further from the truth. In fact, many market pundits describe stocks as “inflation pass-through securities.”

For example, let’s look at a company like GoPro (GPRO), which makes high-definition video cameras used in extreme sports. This is not a recommendation for GoPro—but the company is a good example because of its single uniform product.

Let’s say that due to a semiconductor shortage, the company’s input costs rise 10% (this is an example of cost-push inflation discussed earlier). GoPro then raises its prices by 10%, increasing the company’s earnings per share by 10% and sending shares up by 10%.

Now, this is a very simplified example that doesn’t work perfectly across all sectors, but the point remains that stocks pass through inflation better than other investment vehicles.

The second inflation-proofing strategy is to own  hard assets.

Hard assets are things that have intrinsic value. They’re something you can actually touch, like a gold bar or a building. Goods you can physically hold in your hand and exchange for other goods are much more valuable in a high-inflation environment than paper cash (which has no intrinsic value) or securities like stocks and bonds.

When inflation is rising, you can make a good return by simply buying and storing goods whose prices will likely keep rising. As they appreciate in price, you can either sell them at a profit or use them yourself.

The third inflation-proofing strategy builds on the second one. Those rising hard asset prices are simply the inverse of a falling currency.

As we discussed earlier, high inflation often arises when the Federal Reserve increases the money supply quickly. When there are more dollars in the system, each dollar is worth less than before, pushing the overall value of the dollar downward.

Now, since most commodities like oil, corn, and gold are denominated in US dollars, their prices rise when the value of the dollar falls. You can take advantage of this by buying currency futures, or more simply, buying currency ETFs. Just make sure the currencies you buy are trending higher against the greenback.

Wrap-Up

As Milton Friedman said, inflation is “always and everywhere a monetary phenomenon.” As long as we have money and central banks, we will have to deal with inflation.

It is an ever-present part of a growing and functioning economy, and it isn’t going anywhere. We all need to be ready for it.

subscribers@mauldineconomics.com

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