In this post I wanted to dive into what exactly is inflation, however first off why cover it, it is important to cover because it effects assets, assets that commonly traders and investors trade.
What is Inflation?
Firstly, inflation is what exactly? Inflation is the measure of how much currency loses value per year against other products or services. It is a averaged out measurement that consists of food costs, housing costs, services costs, etc. Another way of putting it, it is a average measure of price rises against the currency you hold.
As an example how much rent went up or down that year on average as a percentage compared to the previous years average, how much milk went up or down, how much petrol went up or down, etc, overall it is a measurement of the average rise in costs of products and services for the average person that year compared to the previous years average. The rise in costs verse the dollar that is. Mostly it is a flawed metric because it can be manipulated by governments or central banks, this can be done via the price setting ( such as free childcare or overly taxed alcohol or tobacco ) of some products or services in the indexation of its formula, in other words the number is open for manipulation. What does this mean, well it means that real inflation average is often much higher than reported.
What Causes Inflation?
Okay, now let’s break down what causes inflation. This is important to begin to understand why inflation will rise or fall during certain times. That way you can be more aware of how it may effect certain assets over time.
Money Expansion Inflation
The most common cause of inflation is money expansion, this is caused by expanding the money supply each year, money expansion comes from two main factors, government debt ( money printing debt and non money printing debt ) and housing debt. As people and governments take on loans this expands the money supply over time as it is paid back. Quite simple for people to understand. As an example if the money expansion increases by 8% in a single year, then over time that amount of money will come into supply as the loan is repaid, this causes over time as long as supply and demand averages remain around the same around 8% inflation.
When money supply increases and the supply and demand ratios of products and services remain around the same inflation tends to be around the expansion of money amount. If it is debt based expansion it happens over time as that money slowly enters the circulating supply of that country. Sometimes this can be delayed by locking money in bonds and incentivizing that money to remain in bonds and other money products.
When people take on home loans the same applies, money is increased and over time that money comes into circulating supply thus causing inflation. More money chasing the same amount of goods, means that money loses value over time. Another cause of Money Expansion is QE or similar programs central banks use to stimulate economies during recessionary periods. This also causes inflation over time, however not at the time as money is locked up in what is called bonds and treasuries. A person can measure money expansion by looking at M1 and M2 numbers for that particular country.
Supply/Demand Inflation
Supply/Demand Inflation is the rising or lowering of prices based on supply vs demand of that product or service, this can be seen with housing in Australia at the moment as an example which is partly overvalued at the moment partly due to a temporary limited supply.
If supply goes up rapidly in the future then prices will decline, if home loan demand diminishes then prices decline as well. One way of looking at it is debt can cause the price of unlimited supply assets to be higher than they should be for periods of time because the supply is limited temporarily. It is important to understand that a near infinite amount of houses or apartments can be built, why, because there is plenty of land in Australia, it is not a limited asset like many claim, more so like a consumer product like corn, wheat or cocoa, however these as also effected by inflation, it is just when supply gets limited combined with inflationary pressures prices can become extremely overvalued even for products with a near limitless supply, thus causing prices beyond what the market can handle and thus a housing crisis or similar.
To summarize when supply is restricted prices tend to rise and when supply increases prices tend to drop over time. Money expansion inflation creates a bit of a floor for this over time however it is only part of the equation when prices get over inflated due to supply constraints.
This is why fruit, meat and vegetables tend to fluctuate in price over time, this is based on how much supply there is in comparison to the general overall demand. This is also why fruit and vegetables prices can remain the same price or even drop in price during high inflationary periods, why, because farmers can always grow more of that vegetable or fruit that year or that year supply may increase due to great growing conditions.
Supply / demand inflation is often temporary and not long lasting as supply imbalances improve from the free market. Basically put, the free market incentivizes increasing the supply in order to make more profit that year.
Often governments and central banks claim or suggest this is the only type of inflation, however they are being dishonest, they deliberately do this because they do not want the masses to know exactly where inflation comes from, from money printing, expansion of debt for government spending.
If people knew more about how fiat works they may demand that the government ban or restrict money printing ( often referred to as QE ). Maybe then there would be protests asking to ban it or limit it considering inflation is the cause of most economic problems.
Asset Price Inflation
Another factor effecting inflation is the price of certain assets, certain assets impact inflation for the whole world, one of those assets is Crude Oil. When Crude Oil is high in price it causes the price of many products to rise as well, why, because the transport industry is reliant on the price of Petrol and Diesel remaining low, if it is not low they are forced to pass the extra costs on to businesses in order to cover the higher costs of transport, when those costs are passed on to those businesses, they are then passed on to consumers in the form of price rises in order to cover those extra transport costs and thus we pay more in the supermarket. Thus more inflation.
When petrol is cheap countries economies tend to function normally, when petrol is expensive countries economies suffer. For more on Crude Oil and its impact on inflation at the moment click here.
Other assets that effect inflation for everyone are high housing costs, high electricity costs and high natural gas costs. Why, because the higher costs are passed on to the users of these products ( which is everyone ). High electricity costs and higher gas costs are then absorbed by consumer products.
There is an old saying, however the saying is true, if you want a strong economy, you need cheap petrol, cheap electricity and cheap gas. Cheap reliable energy is what drives an economy, when they are expensive almost no one benefits from it.
Why Do Central Banks Raise or Lower Interest Rates?
Interest rates impact inflation. When interest rates are lower people lend more thus causing more inflation in the future, when central banks raise interest rates lending is reduced because demand for loans drops, this then reduces debt based inflation over time. This raising or lowering of interest rates proves that Money Expansion as I discussed earlier is the number one cause of inflation, why, because when they raise interest rates people reduce or stop borrowing money for home loans, cars, etc. This in turn reduces debt based inflation over time. This combined with potential ( not always ) lower government spending from debt ( than during low inflation periods ) and inflation over time goes down, simply put, when money expansion reduces, so does inflation.
As an example, if say money expansion drops to 2% to 3% per year then in time future inflation will be 2% to 3%, of course like I mentioned earlier other normal market based supply demand inflationary factors will still exist impacting that amount of inflation at that time.
How Does this Impact Markets?
Now that I have covered all the basics, I am pretty sure I covered everything, how does inflation impact assets or markets over time. Over time it means assets will generally rise in the long term, in particular limited supply assets like $GOLD, $SILVER, other limited supply commodities, $BTC ( and other quality crypto like $XRP and $ETH ) and quality stocks. Understanding this as an investor or trader will help give a trader an edge for valuing that asset over time.
Essentially as long as a asset has demand inflation will be a part of what causes that asset over time to rise, the stronger the demand the more it will rise over time.
