If you want to get wealthy, you need to pay attention to the inflation. Otherwise, you could end up poorer in real terms despite that you are getting richer in nominal terms. Most people know that inflation is the increase in the general level of prices for goods and services. You hear a lot about inflation and CPI in media. But is inflation a problem?
First of all, let’s define inflation. We simply define inflation as the increase in the general level of goods and services which is measured as a percentage, generally over the last 12 months. The CPI, Consumer Price Index, is often used as the rate of inflation. If the inflation is below zero it is called deflation. If the inflation gets very high it is called hyperinflation. There is no strict definition of hyperinflation, but we are talking about inflation of at least 50% in a year, often much higher.
Persistent inflation is a modern phenomenon, before the twentieth century the price level did not change much for centuries. During war prices went up but after the war, the prices returned to the pre-war level. When looking at the general price level in Western Europe from the Middle Ages up to the 20th century, the period from the beginning of the 15th century to the middle of the 16th century stands out. It is known as the great price revolution. It is the only time of consistent inflation for a long period of time. But despite that the price increase looks dramatic compared with earlier and later periods, it was just slightly above one percent per year. This increase is in price level has been explained by the inflow of gold and silver from the New World. But some researchers think that other factors also contributed to the increase in prices.
Nowadays, a little bit of inflation is generally considered as a good thing. At least as long as the rate of inflation is predictable. The reasons given why a little bit of inflation is good are not very convincing but almost every economists agree on that a little bit of inflation is a price well worth paying to avoid deflation. Deflation decreases the economic activity. After all, why buy something today, a couple of month later on it will be cheaper. Actually, in times of deflation saving is good, the value of the money goes up. Debtors will be in trouble, their debt grows in value, in real terms, so they will have to cut down on expenses. All this means that the economy slows down and things just get worse. It has turned out to be very difficult to get the economy going again so governments want to avoid deflation.
High inflation, especially if it was unpredicted, generally redistributes wealth. For some people it is very difficult to protect themselves from inflation. People on fixed income, such as pensioners, fall into this category. For debtors on the other hand, high inflation is often beneficial, the real value of their debt decreases. If loan has been used to buy assets, such as real estate, it gets even better since inflation typically increases asset prices.
At the moment, the official rate of inflation in most western countries is low so inflation seems not to be a problem. But it is good to be aware that official inflation figures are not always reflecting the true increase in living expenses. Some people think that governments change the way of calculating the inflation so that it looks low and stable. The US is a good example of this, here two creative ways are being used to keep the official rate inflation down. One is the substitute effect. If something gets too expensive, the consumer is supposed to buy less of it and substitute it with something cheaper. For example, if beef becomes too expensive, customers are supposed to eat something cheaper, such as chicken. The other way that helps the official inflation to remain low is quality improvement. Since the quality of some goods is improving, price increases are not counted as inflation, it is supposed to be due to the increased quality. Actually, this was just two examples, the calculation of the official CPI figure in the US has been changed a lot over the years. Almost every change has lowered the CPI figure. According to shadowstats.com, the current CPI, which is around two percent, is about three percent lower than what it would be if the formula from 1990 was used. If the CPI is calculated using the formula from 1980, the difference would be even bigger.
So why are the governments understating the real inflation? Well, some people point out that for the governments with a lot of debt, high inflation will decrease the real value of the debt. Low official CPI also helps the government to keep its expenses down, a lot of expenses are pegged to the CPI.
As an investor, is inflation a problem? It depends on how high the inflation is and if it is predictable. Hyperinflation will make money almost worthless but it will also wipe out debt. Deflation on the other hand, will make money more valuable and debtors will suffer. Deflation is unlikely, central banks and governments want to avoid deflation at all costs. They are prepared to accept higher inflation in order to avoid deflation. If you believe governments will keep on printing money and that the inflation will run out of control, gold is the classic solution. Real estate, cash-positive, and quality shares, which pay dividend, are also regarded as good investments in times of high inflation. On the other hand, bonds, bank accounts and cash will be poor choices. Note that while debtors will gain from high inflation, too much debt may cause serious trouble since interest rates are likely to go up as well. Your investments should generate a positive cash flow.