What is inflation?

Inflation is a rise in prices over a given period of time. As the general price level rises, the purchasing power of each unit of currency buys fewer goods and services over time. The common measure of inflation is the inflation rate. Certain assets are more or less affected by inflation, such as gold. Cryptocurrencies and digital assets like Bitcoin are touted as hedges against inflation too. In this article, we’ll delve into all of this and more.

Table of Contents

  1. Inflation erodes purchasing power
  2. Kinds of inflation
  3. Measuring inflation
  4. Challenges of measuring inflation
  5. What causes inflation?
  6. Is inflation bad?
  7. How to protect against inflation

Inflation erodes purchasing power

Purchasing power is the amount of goods and services that can be purchased with a unit of currency. For example, if one dollar could buy a gallon of milk 20 years ago, but now it takes two dollars for a gallon of milk, then the Dollar’s purchasing power has been reduced by half.

Today, most economists favor a low and steady rate of inflation, yet the public does not. It is easy to understand why people dislike inflation since it reduces purchasing power. The charts below show just how much even the “strongest” fiat currencies have lost their purchasing power over time.

Dollar: USD purchasing power

Euro: EUR purchasing power

Pound: GBP purchasing power Image from DollarDaze

Of course, there is always the fear that purchasing power can be reduced to almost nothing. This is called hyperinflation. There are many examples throughout history of hyperinflation destabilizing society. In 1923 Germany experienced hyperinflation

Hyperinflation

Children use bundles of German marks as building blocks.

It is important to keep in mind inflation when protecting your wealth. Simply saving money in a bank account is not enough to escape inflation’s purchasing-power-destroying effects. You must find a hedge against inflation. In the remainder of this article we describe in more detail inflation and how it is measured, and how to protect yourself against it.

Kinds of inflation

Inflation can show up in different places in the economy and can be expressed in different ways. In this section we look at some common places inflation is focused on.

Consumer prices: It is hard to capture the increases in prices of goods and services that people normally use. The problem starts with how to define “normally use?” Common categories to measure include: housing, transportation, food and beverages, medical care, education, recreation, and apparel. Those categories are further subdivided, for example food consists of:

  • Food at home

    • Cereals and bakery products
    • Meats, poultry, fish, and eggs
    • Dairy and related products
    • Fruits and vegetables
    • Nonalcoholic beverages and beverage materials
    • Other food at home
  • Food away from home

Shrinkflation: Instead of increasing the price of a good, the quantity or quality is reduced while the price remains the same, or increases slightly. Critics of shrinkflation point out two main concerns. First, it is a “stealth” way to increase the price of a product that many consumers might not be aware of. Second, shrinkflation is much harder to detect when attempting to measure inflation. This can contribute to governments implementing poor policy because their measurements of inflation are less accurate.

Shrinkflation

The old Gatorade bottle is on the left, the new is on the right. Image from Quartz on shrinkflation.

Wages: Wage inflation is often called “sticky” inflation, because unlike prices in goods and services, once wages begin to increase it tends to be more difficult to bring those increases down. People do not like wage cuts. When wages begin to rise, it can lead to a wage-price spiral.

Wage-price spiral Image from Economicshelp

Measuring inflation

There are many ways to measure inflation

The Consumer Price Index (CPI) measures a weighted average of the price change in select goods and services that consumers need. This includes housing, transportation, and food.

Core CPI is a measure of inflation for a subset of CPI that excludes food and energy prices; the thought being that food and energy prices experience dramatic swings in price in the short term. The high price variance of food and energy can make it more difficult to detect long term trends in inflation.

The Producer Price Index (PPI) measures a narrower part of the economy, specifically changes in prices received by domestic producers. PPI is a measure of inflation from the perspective of sellers as opposed to CPI which measures it from the buyer. PPI can lead CPI, as it shows the pressure being put on sellers by the costs of their materials. That price pressure is often passed on to consumers, showing up later in the CPI.

Challenges of measuring inflation

Measuring inflation has many challenges. First, it requires tracking changes in the price level. The price level is the average of current prices of all goods and services in an economy. While it’s easy to measure the price changes of individual goods and services, it’s functionally impossible to measure the price changes of all possible goods and services in an economy. Thus, measuring inflation will always fall short of capturing the actual inflation rate.

Another challenge that is difficult to account for is that inflation measurements must ignore changes in price that occur for reasons such as volume, quality, or performance. For example, if a cup of coffee’s price increases from 1.00 USD to 1.50 USD but the quantity doubles, then this is not inflation, it’s actually the opposite — deflation!

Other cost changes are even harder to quantify as inflation or deflation. For example, in 2006 the industry leading mobile device BlackBerry Pearl was a major hit, costing $400. A top spec smartphone in 2022 costs around $1,200, but can do so much more. How much of the $800 price increase is inflation compared to an expansion of functions, quality, and value?

Ultimately, it’s important to keep in mind that measures of inflation, while extremely useful, are imperfect.

What causes inflation?

There are two main schools of thought on what causes inflation. One group believes the most significant factor is the money supply. The other group believes the most important factor is the supply and demand dynamic.

Money supply: When a government creates more money, prices can rise as the money enters general circulation. This is particularly true if the money created is not used to create real economic growth in the economy. People often move their wealth out of fiat currency for this reason. Traditional stores of value like gold have a low supply increase rate. Only a certain amount is taken out of the ground, processed, and delivered each year. Real estate supply increases are practically zero, though it does exist. One reason that Bitcoin has a fixed supply is to make sure it can’t be debased like fiat currencies, which are government controlled.

Supply and demand: Certain changes in supply and demand can cause prices to increase over time. The two major sources of inflation from supply and demand changes are:

  • Demand-pull: Increased demand while supply remains relatively steady causes a shortage of supply, creating higher prices. For example, an increase in demand for cars leads to higher car prices in new and used cars. Demand lead inflation can be seen as good since it can encourage economic growth by stimulating investment and expansion to meet the demand.
  • Cost-push: Also called a “supply shock,” a drop in supply while demand remains steady leads to higher prices. For example, a sudden decrease in the supply of oil leads to an increase in the oil price.

Is inflation bad?

Like most things, too much is generally considered bad as is too little. High inflation erodes the purchasing power of people who have saved and hurts or closes businesses who now have to focus on inflation risks. In extreme and persistent inflation environments, this can lead to hyperinflation, where a loss of confidence of the currency leads to holders abandoning it entirely in favor of foreign currencies.

Conversely, deflation can lead to a situation where decreases in the price level lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in the price level. A deflationary spiral.

Many governmental policymakers want to target mild inflation. Mild inflation can lead to asset appreciation, encouraging investment. It also discourages saving in favor of spending in the economy. On the other hand, it makes goods and services more expensive, which can be unhealthy if wages do not also rise with the inflation rate.

How to protect against inflation

A store of value (SoV) is the best way to preserve your wealth. Broadly speaking, a store of value is any object that retains purchasing power into the future, and can be readily exchanged for something else. In other words:

  • A store of value should be worth the same or more over time.
  • A store of value must be exchangeable with something else (like gold, or dollars).

SoVs with low or no increasing supply are considered to be the best way to protect against inflation. This is why currencies, which are considered stores of value but have a mechanism to dramatically increase the supply with a push of a button, make a poor hedge against inflation. SoVs like real estate, gold, and Bitcoin are great hedges against inflation.

Real estate: Land has almost zero increased supply (though it does exist).

Gold: The supply of gold is increasing, but the rate is low and relatively fixed. It takes significant resources to obtain it. For example, digging it out of the earth and refining it.

Bitcoin: Bitcoin’s current supply is increasing, but the overall supply is fixed at 21 million. Of that total supply, 19.1 million has been released as of 2022.

For a more thorough look at Bitcoin as a store of value, read this article.

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