Why does the government want inflation effectively devaluing our hard-earned money? learn how as an investor you can work with inflation.
What is inflation?
Inflation is the rate at which prices increase each unit of currency buys fewer goods or services. Another way of putting it is that our hard-earned cash decreases in value by inflation over time. Our currencies such as the US dollar, British pounds or whichever currency in question are all subjected to devaluation over time.
Inflation is normally measured with the consumer prices index as a percentage CPI for short. CPI looks at the prices of thousands of things we spend money on such as prices of stamps, transportation cost, or rent, payment groceries, and so on.
If the annual inflation is 3% on average we are required to pay three percent more for the same goods or services compared to 12 months earlier. If wages don’t keep up with inflation our standard of living or our purchasing power falls.
For example in the USA in 1988 a loaf of bread is $0.59 and in 2020 it is about $3.00. There are a few reasons why inflation occurs, this is partly due to the use of fiat currency and how the government manages our economy.
The most common reason for sustained inflation is caused by the rate of money supply or the rate of money printing by the government being faster than the rate of economic growth.
Another way the government could influence inflation is by altering the base interest rate or the federal funds rate in the US. The base interest rate influences, what we get paid on our savings account and also what rate the bank charges us to obtain a loan like a mortgage.
This change in base interest rate influences our spending and saving behavior.
Why government actively maintains inflation?
Let’s go through some of the reasons why government actively maintains inflation.
- To sustain economic growth inflation encourages people to buy products as soon as they are needed. If inflation is expected by a buyer there is an incentive to purchase the products sooner or later and continually stimulate the economic growth.
As opposed to deflation if prices are expected to reduce overtime buyers will wait as long as possible before buying what is needed which in turn will negatively impact the economic growth therefore inflation is also to reduce the chances of deflation.
- When we buy or spend more to help stimulate the economy it also encourages companies to put up wages and this produces a few good factors for employees.
Even if your wages increase at a lower than the inflation rate employees feel they are getting paid more than the previous years because numerically the wages have gone up.
For example, people feel good when they compare their salary with previous years or with their predecessors like their parents who may be in the same career such as being a teacher who used to earn significantly less at least numerically.
However, they may not actually be wealthier despite earning numerically higher wages as what is important is the actual purchasing power which has been eroded by inflation in London for example the median gross income in 2002 was £25,000 and has increased to nearly £37,000.
In 2019 this is a 48% increase in median income over that period For the same period the median house prices in London were £170,000 in 2002 and have gone up to £457,000 in 2019 which is a 168% increase in price.
Therefore although numerically the income has increased the purchasing power has significantly reduced over those two periods.
- One of the most important benefits that the government gains from actively maintaining a degree of inflation is lowering the value of their debt. Most governments around the world have debt that requires to be serviced and possibly repaid at some point.
They do this by printing more money and as a result, also promoting inflation the governments can effectively reduce the actual value of the debt by maintaining high inflation over several years.
For example, a debt of $1 million in the year 2000 has a very different value to a debt of $1 million in the year 2020 For countries which the tax bracket are not indexed to inflation more people are effectively pushed into higher tax brackets but may not actually gain any wealthier or increase in their purchasing power.
This enables the government to collect more tax revenue even when we have not earned more money in real terms
Who gets affected by inflation?
Employees and Employers:
In general, most are negatively affected by inflation, both employees and employers increases in employees wages are often lower than the inflation rate particularly for those who have a fixed income. This is perfectly highlighted in the example above with the income and property prices in London.
Even for some businesses, the prices of goods or services may not be able to be increased with or higher than the inflation rate. This is due to business competition and consumer expectations.
Therefore the businesses would effectively suffer from a reduced profit margin if the prices cannot be increased at least in line with the inflation rate.
poor and the middle class:
Inflation disaffects almost everyone but it negatively affects the poor and the middle class the hardest. The negative impact of inflation tends not to affect the wealthy to the same degree this is because a higher proportion of wealthy people hold assets such as stocks and shares and properties which are largely unaffected by the effects of inflation.
Unfortunately, inflation tends to worsen the wealth inequality due to this.
Inflation is bad for savings. In general, savers will find that the value of their cash savings decreases in real terms over time this is due to the fact that most bank accounts offer interest rates significantly below the inflation rate.
As an example, if we have 3% annual inflation over 10 years average prices of goods and services would have increased by 35% your savings in the bank is unlikely to have grown by 35%.
If hyperinflation were to happen it could erode away one’s savings in a short period of time. Therefore savers will suffer as a result of inflation some call it the stealth tax as this is largely not recognized by many savers.
ROI lower than the inflation rate:
Any form of investment with a return of investment rate lower than the inflation rate will result in a loss in real terms. Similar to the low-interest rate offered by the bank accounts therefore you must ensure all your investments are at least beating the inflation rate to be making a profit.
How do I work with inflation as an investor?
Just do what the banks and the governments do. The banks obtain funds from savers with a lower interest rate as good debt and invest the funds out at a higher interest rate to profit from the difference similarly.
Invest with where inflation rate is less then ROI rate:
In my investment strategies such as investing in property where the return of investment is expected to perform over double-digit percentage annually and to fund this with a good debt such as a mortgage with an interest rate which is currently about 2 to 4%.
The profit is not only made from the difference between the return of investment rate and the mortgage interest rate but also from the erosion of the loan over time due to inflation. This is one of the reasons why government maintains inflation to help reduce the burden of their debt as described previously and you can do the same.
If the inflation is high the rental income will also increase, so is the property prices, and at the same time, the mortgage loan will be eroded by the inflation. Therefore if you learn how to invest well, inflation could be your best friend.
Don’t keep too much in the bank:
In general, avoid leaving too much cash in a bank account as inflation will gradually erode its value over time as previously highlighted, however setting aside some rainy day funds which are easily accessible is important I would aim for 3 to 9 months of expenses worth of cash savings to ensure that one has good cash flow.
Many bankruptcies are the result of poor cash flow and not due to profitability.
Know the ROI:
Whenever I analyze an investment opportunity I need to know the exact return of investment (ROI) rate including any fees charges incurred together with the current inflation rate to achieve a real profit from an investment.
The return of investment (ROI) rate has to be higher than all the costs incurred plus the inflation rate for a real profit to be achieved.
In an example of an investment performing 6% return of investment. If the fund management fees were 2% and a platform fee of 1% and the inflation was 3% effectively this investment has not made any gains.
Unfortunately, most people fall victim to inflation but you will now. I have now shared why inflation is actively maintained by the government and how investment can work well with inflation hope you have gained some value. You can also read the wiki on inflation for its history, measuring.