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What is inflation?

4 Mar

For those of you wanting a fantastic overview on inflation and what effects it can have on society, you must read Culture and Inflation in Weimar Germany.

Here is a short summary what inflation means:

In economic terms, inflation is a measure of the change of prices for goods and services over a period of time.

Different measures of inflation track different goods and services to give consumers and producers an idea of how the overall price of goods and services they use changes over time.

The three most frequently used measures of inflation are:

  1. The Consumer Prices Index (CPI)
  2. The Retail Prices Index (RPI)
  3. Producer Price Index (PPI)

The objective of all these measures is similar but each will vary slightly and, in different countries, their calculation might also vary a little.

CPI, for example, typically takes into account cheaper alternatives if a specific product get too expensive whereas the RPI does not, hence why CPI is usually lower. In the US CPI includes certain housing costs such as rent whereas in the UK, while RPI takes into account mortgage interest payments and council tax, CPI does not.

In the UK the measures of inflation are calculated by the Office for National Statistics and in the US by the Bureau of Labor Statistics.

Is inflation bad?

It depends who is asking.

Simply put, inflation will erode the purchasing power of your money over time. For example in 1970 $10 would have bought you over 16 Big Macs whereas today it barely buys you 2.

In more general terms, $100 in 1970 had the same buying power as almost $600 today. The Bureau of Labor statistics has an entertaining CPI Calculator to measure how much purchasing power the dollar has lost over time.

So is inflation bad?

As a saver, unless you are able to achieve a level of return equal to the level of inflation, your purchasing power will be eroded over time. Typically, interest rates will be higher than inflation meaning that investors are able to achieve a real return on their cash – i.e. a return, net of inflation, that is positive.

However, in today’s zero interest rate environment, with inflation running at approximately 2%, cash savers will get a negative real return of 2% – i.e. their purchasing power will decrease by 2% a year.

Savers are therefore forced into seeking real returns into real assets that entail risks (such as equities, property etc.) if they are to stand any chance of achieving a positive real return. Not great. But this is exactly what the Federal Reserve is trying to get people to do. By keep real interest rates negative, they force savers into investments that, they hope, will kickstart the economy once again. A risky strategy, but more on that later.

Is inflation good?

As a borrower inflation can have its advantages so long as it does not impact your ability to repay your loan.

For example, let’s assume you get a 30-year $100,000 mortgage to buy a house today. For every year that inflation erodes the value of the dollar, the size of your debt – in real terms – falls. Just like the example above, we can assume that if the next 30 years experience similar levels of inflation to the past 30, the real value of your debt will have fallen by approximately 60%.

Mortgages are usually structured to be paid monthly rather than at the end of the term, so the average fall would be closer to 30%, but the example illustrates very clearly that inflation can aid those who borrow in nominal terms.

I wonder why the Fed would want to spur inflation at this moment in time..? I’m sure it’s got nothing to do with the $16.5 trillion in nominal debt owed by the US government…

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