How Does Inflation Work?

As an example, if the rate of inflation with refrigerators is 10% a year, a $700 refrigerator will cost you $770 next year, $847 the year after, and $931.70 the following year. From the viewpoint of the value of your money, $1,000 today will be worth $900 next year in purchasing power compared to today, $810 the next year, and $729 the following year. Inflation does not just happen. It is caused by a broadly based cascade of price increases affecting prices and wages with each increase in prices causing a drive for higher wages. Economists say that this is simply too much money chasing not that many products.

Why Is Inflation a Concern Today?

The huge sums of money spent by the U.S. government to rescue Americans from the economic effects of the Covid-19 crisis were life-saving for many who were out of work and in danger of being thrown out of their home. But, as the economy shows signs of recovering, some of that money may be falling into the “too much money going after too few products” category. The same could be true with Biden’s proposed spending on infrastructure. To the extent that money flows into the economy faster than it can be applied to producing products and services we will have inflation.

How Does the Government Fight Inflation?

At the beginning of the 1970s when inflation was driven up by spending for the Vietnam War and new social programs, President Nixon imposed wage and price controls which were a disaster. The eventual solutions were for the Federal Reserve to reduce their bond purchases and raise interest rates and raise reserve requirement for banks. Raising rates tend to drive money into bonds and long term savings accounts and out of circulation. As rates go up so does the value of the dollar so that imports become cheaper and exports become more expensive and less competitive. The end result is to slow the economy.

How Will Inflation Affect Your Investments?

Extremely low interest rates ever since the Financial Crisis have favored stocks as investments over bonds and bank savings. The stock market today is probably overpriced if compared to what it would be if interest rates were two, three, or four percent higher. If rates were to go up to the teens like in the 1970s we would probably see stagflation in which the economy stagnates while prices keep going up. During the 1970s the best performing investments were gold and real estate. The stock market basically traded sideways during this period. Considering that much of today’s stock market is perhaps overpriced we can probably expect a correction before it goes into sideways mode. This is probably a good time to look at which investments will prosper during an inflationary cycle and which will do poorly and then to adjust your portfolio accordingly.

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