Inflation: What Is It and What Causes It
Well, if you thought you were done hearing about inflation for a while, I’ve got bad news for you - it’s back! Honestly, if you think you will ever be done hearing about inflation, you’re probably in for a surprise. Just like we said last month, inflation is a little like children. Just when you think you’ve sent them off to college, they’re back at your doorstep to take your money - literally.
We ended June on the topic of inflation-adjusted returns, which included a little bit of background info on what inflation is in general, but this week we’ll dive a little bit deeper.
So, What Is It?
So, let’s say you go to buy a banana for one dollar. Five years later, you're craving a banana again, except now it’ll cost you two dollars. What a rip-off! Let’s eat a strawberry instead - except those went up in price, too! And so did the blueberries, the raspberries, and the gas it took to drive to the store to buy the blueberries and strawberries. It’s a monetary massacre! The body of your favorite fruit smoothie is to be buried, mourned, and replaced by off-brand raisin-bran from the 99 cent store. Nobody should be subject to that kind of torture.
Okay, that was dramatic. Inflation won’t kill you, or your spirit (not completely). But it will cause the cost of goods and services to rise which causes the value of your dollar to decline (now’s a good time to check in on your spirit and make sure it’s still kicking).
That is the basics of inflation, and it sounds scary but it is totally normal. It has always been around, and it is probably never going away. So, might as well get comfortable with it, and expect it to come and go pretty often, just like that kid you thought you got rid of, remember?
What Causes Inflation
So, why does the kid keep coming back? Didn’t we give them enough money? Ah, “enough money” - even I laughed at that question. No, inflation, and your kid will probably never get enough. There is a reason, though, and it applies to both of them.
The main reason why they might both keep coming up to mess with your money is if you end up getting more of it. That’s right! Sounds cruel, huh. Check-in with your spirit again. Does it still have a pulse? Great, let’s move forward.
The root of inflation is typically an increase in the amount of money in an economy, which makes the money that exists worth a little less. So, the more money there is, the less valuable it becomes. Ever heard the advice that if you win the lottery, you should tell nobody? That’s because that $20 in the Christmas card won’t seem so stupendous if people know you could throw in $50. All of a sudden Christmas is composed of Tesla’s instead of toasters, and there goes your money - off to the massacre.
But how exactly does an increase in money supply and decrease in dollar value impact more specific things, like the price of our bananas? And how do we ask it very nicely to please stop it?
Well, there are a couple of ways that this happens. All of which cannot be stopped, even if we ask very very kindly. Try asking your child to please stop needing your money. Let me know when that works out for you, I’ll wait.
I’ll probably be waiting a long time, which means inflation will probably go up a little bit more, and here are a couple of reasons why:
So, we have more money in the economy, which means more money circulating around for people to use. What happens when you give humans money? We promptly deposit it into a savings account for a rainy day like the smart and stable species that we are. Just kidding. We spend it!
We all haul our greedy, grubby hands to the mall so we can start buying all the Teslas and toasters we want. Except, the Tesla and toaster manufacturers weren’t ready for us to come knocking on their door in such massive quantities. There is too much demand and not enough supply. So, what do they do? They keep the cost of their goods at exactly the same price as a thank you for all of the lovely new customers coming to buy their product. Just kidding. They jack up the price!
They know you want it more, so they know you will spend more. Their product is more valuable because there is less of it than what is desired (the opposite of what has happened to money), so they drive the price up to match it. Boom! The price of goods and services rises while the value of the dollar declines. Demand-pull inflation. Lovely, isn’t it?
So, imagine demand remains the same. It doesn’t rise. We don’t need toasters or Teslas anymore than we did yesterday. But the cost of raw materials does rise. For example, the cost of metal was $20 per pound (in our imaginary world), then inflation made it so $20 started to be worth more like $10. Now we need $40 to buy metal, and your $100 toaster costs more like $400. Suddenly we are all frying our bread in pans like the good old days. Or eating it soft and room-temperature, the way God intended (which is what we keep telling ourselves). Frying pan, soft, whatever - anything except 99 cent raisin bran. We can’t go back there.
This one is a little bit more long-term, and it relies on the fact that we expect inflation to continue over time. The expectation that inflation will persist means that we collectively push for rises in wages/prices of service today to help balance out the impact of inflation we expect to experience tomorrow. Employees continue to demand higher salaries or minimum wages, assuming that down the road their current rates will depreciate in value alongside the dollar. Eventually, employers have to increase the cost of goods/services to match the increasing wages. Boom! Built-in inflation. Built by yours truly - each other! I know it seems like a cycle of us creating a problem by trying to avoid it, but we have good intentions behind it. Sort of like an insurance policy (which is what we keep telling ourselves).
So, there are a few ways inflation happens, and there’s no way to stop it from happening. Of course, we will go through periods of deflation, where the value of the dollar increases, but don’t worry. Inflation will likely be right behind. This all sounds very bad, but don’t make the mistake of thinking that inflation is doom and doom only. We said inflation is like our kids, right? This means there are going to be parts of it that we love, parts of it that we hate, and parts of it that we hate but we have to pretend that we love because it’s not going anywhere. All of that will be spelled out in the next few parts of this series, so stay tuned! Enjoy a fruit smoothie or banana toast while you wait.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes.
Investing involves risks including possible loss of principal. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results. Investing in stock includes numerous specific risks including the fluctuation of dividends, loss of principal, and potential illiquidity of the investment in a falling market. Bonds are subject to market and interest rate risk if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax.
Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.
Options are not suitable for all investors and certain option strategies may expose investors to significant potential losses such as losing the entire amount paid for the option. The fast price swings in currencies will result in significant volatility in an investor’s holdings. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities.