What is Inflation, Really?
I can remember learning about inflation in school. Germany’s economy during the Weimar Republic falling apart at the seams. Crazed civilians running around with wheelbarrows full of cash to buy a loaf of bread. Let me start by saying, NO, this is not the normal inflation that occurs in our economy. This was an extreme case scenario of hyperinflation and doesn’t reflect the typical effects of inflation. Thank goodness!
When you hear talk in the media of “next next recession” or “inflation” or anything of this nature, let me tell you, it is not a reason to panic. Making fear based decisions is actually the worst thing you can do, but we’ll get to that in a minute.
Let’s start with the basics.
What is inflation, really?
Simply put, inflation is the measure of the increase of costs of goods and services. This in turn means that as the cost of these goods and services go up, the value of our dollar goes down. This can happen a couple of different ways…
Supply and Demand:Think of something that’s released in a limited quantity. (ex: limited pairs of a certain type of shoe, or something that is difficult to make) We call this scarcity. And it creates room for resellers to buy the product and then sell it at a higher rate.
Cost Increase: When the cost of materials to make a certain product go up due to scarcity of resources (either physical resources or manpower to create the product), this in turn raises the price of the product. Think of the great avocado drought. Okay, I don’t know if it was actually called that… but for whatever reason avocado season’s crop return didn’t yield what it normally does a few years ago… so farmers had to charge more for avocados to make up for the deficit and keep things competitive between buyers… it was a sad day for everyone who wanted avocado toast.
Built-in: As costs increase, workers expect (and demand) higher pay to maintain the cost of living. However, this increase in pay results in companies charging more for products and services to make more money to pay employees, which then leads to higher prices for the goods and services, which then lead to demands for wage increases… and so the spiral begins. Because of this circular dependence, built-in inflation is sometimes also referred to as the wage-price spiral.
So what happens when inflation is present in our economy? (And are there any benefits?)
What happens is what economists call an erosion of purchasing power. Meaning, the dollars that we have today can’t buy the things that we want and need yesterday. When costs of goods increase, the same twenty dollar bill you have in your wallet won’t buy you the same products it could yesterday. It will actually buy you less. Make sense?
So if your twenty dollars doesn’t buy you the same things, or your gas tank costs double — it results in a decrease in purchasing power. Queue: FEAR. The frantic voice in your head telling you, “Buy now or you will never have this opportunity again!”
Fear is a terrible place to make investment decisions from. It’s what drove me to buy a home at the height of the market in 2006. Which, I’ve shared before, was not a smart decision that ended up losing me a lot of money. Herd mentality rules in financial crisis, and it often leads to poor decisions.
So, is this all just happening, or is somebody going to do something?
There is a weapon against inflation, and it lies within the power of interest rates. The Federal Reserve increases rates of loans given to banks and businesses from the government to invest in new technology or employment. This is turn slows production, which then controls the growth of the economy.
And this, is your moment, to carpe diem. One of the only benefits is in relation to mortgages. I know I know, “so bias”, but it’s the truth! Stick with me…
We find this benefit in what is called the “time value of money.” And it only occurs in fixed rate loans.
Let’s say you borrow sixty-thousand dollars to buy a home. The amount loaned to you by the bank is always going to be, sixty-thousand dollars. No matter what. The catch is, that sixty-thousand dollars may not have the same value 30 years from now. Remember what happens with inflation — the cost of goods and services goes up, and the power or value of our dollars go down. So your sixty-thousand dollar loan itself is worth less and less. When you attach it to an asset like a home, that asset will stay constant with whatever the value of money is today. Even though the value of YOUR loan is valued on what it was worth a long time ago. Pretty cool, right?
There’s always a silver-lining, there’s never a good time to make a decision out of fear, and inflation is a normal occurrence in any economy. Keep adding knowledge and wisdom to your tool belt, and I trust you will make the smart financial decisions that are right for you and your family. The key is to stay educated! What are the biggest takeaways you have about inflation? Let us know in the comments below!