The Inflation Effect

Nothing escapes inflation. Not home loans. Not fuel and food prices. Not investments, and definitely not Bitcoin and other cryptocurrencies. Not yet, anyway. Even powerful nation states seem to sway like seaweed in the current of inflation while doing their best with the tools at hand to manage it. But what is this monetary phenomenon and why is the financial system and life in general so vulnerable to its whims? 

What is inflation?

Inflation plays out in many ways, but the most obvious symptom is an increase in the cost of living that usually coincides with a decline in the buying power of money. Inflation can lead to an increase in the price of bread while at the same time eroding the value of the money in your pocket. 

What is considered normal inflation? 

It differs from country to country, but the Federal Reserve, the central bank in the US, targets a long-term inflation rate of 2%. A developing country like South Africa tries to keep its inflation rate around 4%. 

Where is inflation at the moment? 

It’s hovering around 8% in the US and 5.8% in the EU. 

Wait a sec, to get back to bread, what does it have to do with inflation?

Nothing and everything. In broad strokes, the cause of inflation is twofold. On the one hand, an increase in general demand in a thriving economy, also referred to as a “hot” economy, causes the price of consumer goods and other items to rise due to demand outstripping supply. This is known as demand-pull inflation. 

The other major cause of inflation is on the supply side, which is known as cost-push inflation. A supply squeeze can be caused by a number of things, ranging from a change in monetary policy to natural catastrophes, or any other events that cause supply chain disruption.

The current inflation we are experiencing is a concoction of both demand-pull and cost-push factors. 

Researchers from the White House found that the current inflation scenario, in the US, at least, is comparable to the period after World War 2, which resulted from “the elimination of price controls, supply shortages, and pent up demand.” In plain language: A shortage of stuff coupled with a collective urge to spend money. 

So, bread… 

If certain events were to cause a disruption in the global supply chain of grain, it would lead to a supply squeeze, driving up grain prices and so too the price of bread, in which wheat, a grain, is the main ingredient. But it goes further. 

Grain is also a staple food of livestock, which means that inflated grain prices lead to more expensive meat and dairy products. The same goes for shortages of other commodities such as oil, which results in fuel price hikes. This means that it’s more expensive to transport products from manufacturers and farmers to retailers, which leads to the higher price tag you see on shelves in the supermarket.  

What causes my money to devalue? 

Your money doesn’t actually lose value but rather loses its purchasing power. As inflation rises, you can buy less and less with the same amount of money. 

It’s not really an issue when inflation hangs around 1 or 2% per year, which can be levelled out by economic growth, but a steep and sustained rise in inflation of 5% or more means that in 10 years it would be 50% more expensive to get by than it is today. 

Where does inflation come from?

The late economist and Nobel laureate Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” In other words, “Mo money mo problems.” That was Notorious B.I.G. 

Monetarists, a school of thinking in economics to which Friedman belonged, believe that an oversupply of money in an economy, more than what the economy is able to absorb through its output, is the main driver of inflation. Arguably, inflation, as it’s known today, originated with the practice of printing paper money.  

What do we use to measure inflation?

The Consumer Price Index (CPI) is a widely used inflation indicator. It measures how much the average price for a basket of consumer goods and services changes over a specific period of time. 

Why is inflation so hot right now? 

Let’s zoom in on the situation in the US. The pandemic led the US government to hand out stimulus checks and other financial aid measures as part of its $2.2 trillion relief package to soften the economic fallout from the pandemic. In not doing so, the government risked an economic recession, which is marked by two successive quarters of a decline in gross domestic product (GDP). To scrape together money for the stimulus package, the US government took on huge amounts of debt by ‘printing’ Dollars. 

Household savings during this time mounted as there weren’t many avenues for US consumers to spend their money due to Covid-19 restrictions. As economies around the world showed signs of recovery and flung open its doors to consumers, US citizens realised they were sitting on a bunch of saved money and started spending it in a big way. This created a push on the demand-pull side of things, while the supply of items was being hindered by a reduced workforce and other supply chain issues related to the pandemic. 

Critics of the stimulus package argue that the Fed overheated the US economy, leading to a surge in general demand by consumers. There are many complicated versions of the above scenario playing out around the world at the moment. 

Wait, does the Federal Reserve literally print money when it needs it? 

Well, sort of, but it’s a little more complicated. The Fed doesn’t actually print money. It buys financial assets from commercial banks, usually in the form of government bonds, and credits the amount to the bank’s account. Remember, in the same way that we hold cash in a commercial bank account, commercial banks hold reserves at the central bank. So, the Fed doesn’t print money but creates digital money in this roundabout way. 

What can governments do about inflation? 

Think of inflation as a pot of boiling water that is always threatening to bubble over and ruin the stovetop, but the water must boil for it to be of any use. Governments are constantly trying to keep inflation at just the right temperature, using various tools to turn up the heat or bring it down to a simmer. 

Each government follows its own approach to control inflation but the most recited method is by hiking or lowering interest rates. Using monetary policy, the government lowers interest rates to heat up the economy and encourage people and businesses to borrow and spend money. On the other hand, if the government increases interest rates, it becomes more expensive to borrow money and it encourages saving, as investors see more potential to earn interest. 

Makes sense, but why does the cryptocurrency market react so severely to interest rate announcements? 

Rate hike announcements often frazzle investment markets, not just cryptocurrency investors. The market generally takes profits from riskier assets, including equity and digital assets, when the Fed announces a rate hike. This can be due to expectations of lower profits by businesses due to a slow economy. Investors may also lean more towards investments that deliver relatively stable, albeit smaller returns, such as bonds or gold, during times of uncertainty. But these sell-offs are usually short-lived and investors tend to quickly shake off the jitters. In fact, Bitcoin and equities rallied in March despite the Fed announcing a rate hike, possibly signalling that the rate hikes have already been priced in. 

Last question, what does it mean if uncertainty is already priced in? 

The markets expected these announcements ahead of time and have already made peace with it happening, which is reflected in the stable price of an asset.  

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