What Is Inflation

What Is Inflation Caused By?

8 min read

Since the beginning of the year, inflation has been a term in everyone’s mind. But what does it mean? Inflation doesn’t only dictate the price of goods and services we purchase. It also affects the way we invest. This year, it’s undeniable that prices for many essential goods have skyrocketed. We would expect our salaries and wages to increase proportionally. Unfortunately, they don’t. This leaves a dent in many people’s pockets. What are the causes behind these price increases? Inflation also has an impact on the stock market. Today’s article will shed light on the various implications of inflation and will answer many questions. 

In a nutshell, inflation decreases the purchasing power of consumers. It is calculated using a standard of a basket of goods every year.

The percentage increase becomes the inflation rate for the year. When the price of the same basket of goods decreases, it’s called deflation.

Deflation occurs when there is a greater supply than demand, or the production process becomes more efficient and cheaper. For example, in the 12 months leading to May 2022, prices increased by over 8%, the highest rate since 1981.

We use the Consumer Price Index (CPI) and the Wholesale Price Index (WPI) to measure such changes. For example, products like gas and oil suffered a much higher price increase. Others, like housing, are beginning to decline. 

When the price of a standard basket of goods steadily increases, wages usually don’t follow suit. So to prevent the prices from getting out of control, banks and governments put in place some measures to keep everything under control. This is when monetarists and Keynesians begin to debate the steps to take. We won’t get into financial details but will look at the basics. 

What Is Inflation

Inflation Causes

To begin with, inflation is caused when the supply of a currency increases. Recently, many governments worldwide had to print more money to distribute to citizens and businesses and give out loans.

Things seemed under control until the war in Ukraine broke out. Then, the supply and delivery of essential resources, such as oil, gas, and wheat, were disrupted. As a result, finding other, more expensive sources of these products became necessary. 

Three main causes of inflation are printing more money, legally devaluing the currency, and quantitative easing (QE). The latter is a new strategy central banks use to combat inflation and reboot the economy. It has many proponents and opponents. For a more in-depth analysis of QE, you can visit an article we previously published.

Controlling Inflation

Inflation can be controlled. We won’t get into an Econ 101 explanation but will cover the basics. The main objective is price stability while maintaining economic growth. Most importantly, unemployment rates need to remain low. As long as interest rates remain low, consumers will be willing to borrow and spend. 

After the 2008 crisis, many mechanisms were put in place. However, the situation in the world today isn’t new. There have been global wars, pandemics, and recessions before.

We never know how long those events will last. However, today’s governments are mismanaging their response to those events. Consumers are always the ones who have to pay at the expense of the weather gang. 

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Pros and Cons of Inflation

Now that we briefly examined the causes and effects of inflation, we can compare its pros and cons. Inflation has risen much quicker in some countries than in North America and Europe. For example, in Venezuela, inflation reached 1198%.

Sudan and Lebanon are well over 200%. Inflation can reach even developed countries. Turkey and Argentina are good examples. They are in the top 10 this year, 36.1% and 51.2%, respectively. 

1. Pros

Despite all the negativity surrounding inflation, there are some pros. As long as inflation remains contained, things can change for the better.

Inflation can adjust the prices of houses and certain commodities. Homeowners will be happy if prices don’t get out of hand.

There has been a growing issue in major cities like Vancouver, Toronto, and Montreal in Canada. Unfortunately, the US isn’t spared. California, New York, and countless other cities are experiencing the same issue.

A contained increase in prices will bring an increase in wages. As a result, everything will be adjusted, and the economy will continue to grow. However, when things get out of hand, it can lead to consequences that will last for a longer period. 

2. Cons

When price increases aren’t contained, certain issues can arise. Buyers won’t be too happy with the new prices. On the other hand, sellers will be more than delighted. Many global leaders thought the sanctions on Russia would cripple its economy.

However, since Russia is a major exporter of gas and oil, the country is profiting more than ever. The situation has been reversed, and the burden has been passed on to consumers worldwide while Russia is fattening its pockets. 

For investors, rising inflation can be tricky. As we can see, many stock market sectors have been suffering this year. The price of commodities and energy has increased, but they aren’t always socially responsible for our planet.

On the other hand, many sectors, such as tech and financials, have suffered. Popular indexes such as the DJIA and NASDAQ have been down between 18 and 32% year-to-date.

Investors shift to safer assets, and stock markets become a tricky environment. Being on top of our holdings becomes important as they can become very volatile. Some investments are known to hedge against inflation. Let’s take a look.

Hedging and Investing During Periods of High Inflation

During periods of inflation, stocks can increase. However, when we mix a war, uncertainty is created, and safer investments are needed. 

The energy sector is usually a great investment during periods of high inflation. As we can see today, prices tend to increase, and energy companies greatly benefit. 

Next on the list are bonds. Despite being a boring investment, they are a safe way to preserve and grow our capital. Gains are modest, but it’s always better to be in the green than to swim in a red sea. 

When prices increase, commodities become an excellent investment. They are divided into four categories: agricultural products, energy, livestock, and metals. For example, many investors and governments place a significant percentage of their investments into gold. This is because it’s seen as a safe investment during periods of inflation. 

Last on the list are consumer staples products. They are everyday items we use in our households. During the pandemic, stores that sold these items were deemed essential. Growth in this sector is modest, but dividends aren’t. 

Hedging with Crypto

Many investors will recall crypto proponents claiming it can be a good hedge against inflation. The last few weeks and months can easily answer this hypothesis. But unfortunately, crypto is very volatile and isn’t approved in many regions of the world.

Furthermore, new digital currencies pop up every day. Establishing credibility and a reliable hedge for inflation becomes difficult when the currency isn’t well regulated. For example, look at the Luna/Terra scandal.

Limiting the number of digital currencies in place may be better for reestablishing their credibility. Eventually, Ethereum and Bitcoin can become good hedging options during periods of high inflation.

Final Thoughts: What Is Inflation?

To conclude, inflation has been around for ages. Generally, inflation decreases consumers’ purchasing power when wages don’t follow its increase. It can be caused by printing too much money, increased government spending, or legally devaluing the currency. In any case, consumers are the first to be affected by inflation. During every step of production, the price increases. It is reflected in the final price of the item. In 2022, inflation reached a level not seen in 4 decades. There doesn’t seem to be any slowing down. Events on a global scale, like pandemics and wars, disrupt the chain supply and availability of many items. This, in turn, affects the stock market and investors’ allocation between risky and safe investments. 

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