Tag Archives: what is inflation

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…

What is the United States inflation rate?

6 Feb

The Bureau of Labor Statistics reports the CPI-U index. The reported end December number of 1.7% tells us that the price of goods and services has increased by that much over the past year.
Interesting, but it doesn’t tell us much about the future rate of inflation and therefore how it will affect our future purchasing power.

A better indicator of future inflation, one that the Federal Reserve keeps a close eye on, is the 10 year breakeven rate. The breakeven rate is a measure of the expected rate of inflation over a certain period of time. It is calculated by measuring the difference between the nominal yield of government bonds and the real yield of inflation linked government bonds. In this case, the 10 year bonds.

The expected rate of inflation for the next 10 years shows that investors expect inflation rates to rise from 1.7% to 2.6%.

This doesn’t appear at first to be a big change, but as the chart below shows, 2.6% is as high as inflationary expectations were before the crisis, when the economy was growing at a speedy rate and unemployment levels were low.

US inflationary expectations

Given that the economy is stalling and the unemployment rate is at 7.9% what other factors could explain this rise in inflationary expectations?

One likely cause is the FED’s QE program, which has expanded its balance sheet by US$2.5 trillion since 2007. To put this in context, it took almost 100 years for the Fed to build its balance sheet to US$0.9 trillion and it then almost tripled this in the last four years! This new money has essentially been created out of thin air and, as it continues to find its way into the real economy, its effects will increasingly be felt by consumers. The simple economic principle of prices being determined by supply and demand tell us, very simply and elegantly, that once the supply of dollars increases so substantially, surely its price must fall. Or in other words, the price of good relative to the dollar must rise considerably to balance the oversupply of dollars.

Inflationary expectations could rise considerably from here. Watch this space!

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