“Inflation is taxation without legislation.” - Milton Friedman
2022 saw inflation dominate the economic news, with some of the highest inflation rates seen for decades in the US and many other countries.
Inflation isn’t an academic economic phenomenon, it affects us all, from the prices we pay in shops to the interest rates we pay on mortgages and loans, and investments, too.
Expats will have experienced fast rising prices and another result of inflation is that a much stronger dollar may have affected their cross-border investments or money transfers.
In this article, we’ll look at:
• What is inflation?
• What causes inflation?
• How does inflation affect investments?
• Inflation in 2022 and 2023
• Is inflation always bad?
What is inflation?
Inflation is defined as a long-term increase in the prices of goods that reduces the purchasing power of money. Between 1960 and 2021, the average annual inflation rate in the US was 3.8%. In June 2022, it reached 9%.
Indexes like the Consumer Price Index and Wholesale Price Index reflect the inflation rate over time.
Inflation directly impacts the cost of living, which in turn slows economic growth. According to economists' general understanding, prolonged inflation happens when a country's money supply expands faster than its economy grows. Thus, inflation levels can theoretically be controlled by increasing or decreasing the money supply in an economy.
What causes inflation?
Several factors can cause inflation. Here are a few examples:
Cost-push inflation is a rise in the prices of goods and services due to the increase in prices of factors of production. This reduces the supply of goods, causing price increases. For example, when oil prices go up, it increases the general inflation rate because it is a significant factor in production of many goods, as well as transporting them (and transport in general).
Demand-pull inflation is an increase in the price of goods and services due to increased demand. In this scenario, the aggregate demand in an economy is greater than the aggregate supply.
Built-in inflation occurs when consumers anticipate that inflation will go up shortly. As a result, workers may demand more pay due to these common expectations. At the same time, higher earnings can boost goods demand, leading to higher prices.
Money devaluation: Monetarists believe that as the supply of money increases in an economy due to the expansionary policy of central banks, its value goes down. When money's value declines, it loses some of its purchasing power, increasing the relative cost of goods.
Measuring inflation
There are different ways to measure inflation, but the most commonly used is the Consumer Price Index, which measures the increase in price of a ‘basket’ of essential goods and services including basic foods, gas and utilities.
Another useful way to measure and compare inflation between countries is by using the Big Mac Index, which was originally introduced by The Economist magazine in 1986 to compare relative purchasing power between different countries based on just the price of a Big Mac in each country. The increase in the price of a Big Mac in each country is also a good indicator of inflation, though.
How does inflation affect investments?
Understanding the impact of inflation on investments is essential for expat investors, as the rate of inflation is a measure of how quickly an investment loses its real value over time. Thus, investors must ensure that their returns are higher or at least equal to the inflation rate to retain their value.
Liquid assets are affected by inflation in the same ways as other types of investments, with the exception that the returns on liquid assets such as money are typically meagre compared to illiquid assets like shares and bonds. Liquid assets are, therefore, more susceptible to the damaging effects of inflation. As a result, higher inflation rates tend to result in people and corporations holding fewer liquid assets in the overall economy.
Say you have $100 in your account. Your savings would increase to $105 if you earned a 5% interest rate. If inflation is 10% over the same period, an item previously priced at $100 will now cost $110. Despite the growth in your investments, you must spend more money because inflation has increased.
Because the impact of inflation on illiquid assets is less than on liquid assets, people secure their savings by investing them in bonds and stocks.
Inflation in 2022 and 2023
The global COVID-19 pandemic impacted economies negatively. The prolonged lockdowns reduced production and inhibited global freight transport. Businesses are currently attempting to resume normal operations or working to make up lost revenue.
Because the pandemic reduced aggregate demand, there were many layoffs, which reduced disposable income. This spiral caused inflation to rise. In other words, the combination of high demand and inadequate supply following the pandemic has caused prices to soar.
Economists aren’t all in agreement regarding the expected inflation rates in the coming months and years. Numerous analysts are confident that the current inflationary pressures will be short-lived and will soon subside. However, others are less optimistic, claiming that Americans—as well as people in the majority of the other developed economies—must adjust and be ready for higher inflation rates to become endemic.
The more optimistic school of thought maintains that the current price hikes should be resolved as soon as supply chain constraints subside and the post-pandemic rise in demand to purchase items diminishes.
The other school of thought believed that as slower-moving categories like rent join the trend of price hikes, the claim that price increases are only limited to industries impacted by pandemics is starting to falter. Furthermore, Russia’s invasion of Ukraine increased global oil prices, further increasing manufacture and transportation prices globally.
Is inflation always bad?
As long as it is kept under control, a little inflation is required to keep the economy expanding and generally regarded as healthy. This is because inflation reduces unemployment rates. However, if costs keep rising too quickly, it becomes a problem that needs to be addressed. Coupled with stagnant growth, it can lead to stagflation. Rapid inflation usually results in people cutting back on spending and eventually entering a phase that might lead to depression.
There are both winners and losers when it comes to inflation. For example, people who have invested in assets such as gold and cryptocurrencies can benefit from inflation, as these types of assets can often spike in value during times of high inflation. There is also often a higher demand for physical assets, such as art and jewellery in times of inflation.
Conversely, some of the assets that do badly in times of high inflation include cash (in savings accounts for example, as when prices increase, money loses value, reducing the savings' actual worth), and long-term bonds.
Borrowers on variable rates also suffer, as central banks hike interest rates to combat inflation and retail banks follow suit by increasing the borrowing rate. As a result, homeowners with variable mortgage rates may experience considerable increases in their monthly mortgage payments.
High and erratic inflation breeds uncertainty for customers, banks, and businesses alike. There needs to be more investment, which results in slower economic expansion and fewer job opportunities. Therefore, rising inflation over the long run is linked to worsening economic prospects.
If you have any questions, don't hesitate to contact us.
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