What Is Inflation?
Since the beginning of the year, inflation is a term that has been 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 proportionally increase. 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.
What Is Inflation?
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 when the process of production becomes more efficient and cheaper. In the 12 months leading to May 2022, prices increased by over 8%, which is the highest rate since 1981.
We use the Consumer Price Index (CPI) and the Wholesale Price Index (WPI) to measure such changes. Some 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. 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 economical details, but we will take a look at the basics.
To begin with, inflation is caused when the supply of a currency increases. Recently, many governments around the world had to print more money to distribute it to citizens, businesses and to give out loans.
Things seemed under control until the war in Ukraine broke out. The supply and delivery of many essential resources such as oil, gas and wheat were disrupted. It became necessary to find other more expensive sources of these products.
Three of the main causes of inflation are: printing more money, legally devaluing the currency and quantitative easing (QE). The latter is a new strategy used by central banks to combat inflation and to 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.
Inflation can be controlled. We won’t get into an Econ 101 explanation, but we 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. 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.
Pros and Cons of Inflation
Now that we briefly examined the causes and effects of inflation, we can compare its pros and cons. In some countries, inflation has been rising much quicker than in North America and Europe. 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 both in the top 10 this year with 36.1% and 51.2% respectively.
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 as long as prices don’t get out of hand.
In Canada, there has been a growing issue in major cities like Vancouver, Toronto and Montreal. 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. 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 of time.
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 around the world while Russia is fattening its pockets.
For investors, rising inflation can be tricky. As we can see this year, many sectors of the stock market have been suffering. The price of commodities and energy has been increasing, but they aren’t always very socially responsible for our planet.
On the other hand, many sectors such as tech and financials have suffered. In fact, 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. It becomes important to be on top of our holdings 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 very 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 sea of red.
When prices increase, commodities become an excellent investment. They are divided into 4 categories: agricultural products, energy, livestock and metals. Many investors and governments place a significant percentage of their investments into gold. 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 that it can be a good hedge against inflation. The last few weeks and months can easily answer this hypothesis. Crypto is very volatile and isn’t approved in many regions of the world.
Furthermore, every day new digital currencies pop up. It becomes difficult to establish credibility and a reliable hedge for inflation when the currency isn’t well regulated. Look at the Luna/Terra scandal.
Moving forward, it may be better to limit the number of digital currencies in place to reestablish their credibility. Eventually, Ethereum and Bitcoin can become good hedging options during periods of high inflation.
Now You Know What Inflation is
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 by 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 that hasn’t been 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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