Does Inflation Matter?

To most of us, inflation means higher prices.  The grocery bill goes up, it costs more to go to the movies and to buy a car.  But, what else is impacted by inflation?  Is inflation good or bad for your investments? 

The financial media frequently talk about the current inflation rate as well as future expectations.  To understand the impact inflation may have on you, it is helpful to have a basic understanding of what it is and what causes it. 

What is Inflation?

A rise in the general price level is the simplest way to define inflation. You may have heard an older person talk about how different things were back when they were your age.  He or she may recall going to a movie for a dime or paying 50 cents for a gallon of gas. Things have changed!  To see a movie in the theater today, you pay about $15 and gas costs more than $3 per gallon. That’s the impact of inflation!

What Causes Inflation?

Economists wake up in the morning hoping for a chance to debate the causes of inflation.  While there is no one cause universally agreed upon, below are three generally accepted reasons for inflation to increase.

• Demand outweighs Supply.  When demand for goods and services increases at a faster rate than the supply, you have inflation. If it is harder to get something, those who sell that product or service are able to increase the price.  Shortages may occur as a result of a natural disaster. This creates a temporary scarcity as people scramble to purchase the limited supply of goods, causing the prices to skyrocket.  A good example is Hurricane Katrina which caused a spike in gas prices.  A shortage of supply could also be the result of a growing economy.  As people gain confidence regarding their futures, they feel comfortable spending more and, therefore, buy up more products and services.  This imbalance between supply and demand is the most agreed upon cause for inflation.
  
  
• Increased Costs.  Inflation can also occur when manufacturers and businesses raise prices due to an increase in their production costs.  Raw materials, transport expenses, or rising labor costs are potential factors.  For example, when talent is scarce, businesses are required to pay higher wages, to attract and retain their workers.  Companies pass these costs on to customers via higher prices.
  
  
• Too Much Money.   Another cause is the expansion of the money supply.  When this occurs, it creates a situation where the ability to pay more causes prices to increase. The money supply is not just cash, but also credit cards, personal loans, mortgages, and investments.  When there is more money to spend, the price of just about everything will increase, even though neither demand nor supply has changed. The run-up in housing prices in 2005-2007 is an example of too much money in the system.  When people could borrow for virtually nothing with zero money down, it made no sense to rent.  Also, with low interest rates, homeowners used their houses as ATM machines, spending their equity on other goods such as cars and TV’s or buying more houses.

Is Inflation Bad?

Almost everyone thinks inflation is evil, but that’s not necessarily true. Mild inflation, in the range of 2%, is good for the economy, because it can promote consumption without destroying the value of people's savings. As long as inflation stays within limits, it could actually benefit economic growth. If you know the cost of something will go up slightly in the future, you'll be more likely to purchase it now. As people spend, businesses invest in more inventories and hire more people who in turn spend more.  If this effect is mild, savings rates are maintained at an acceptable level. Likewise, increased company revenue can result in increased company stock value.

On the other hand, runaway inflation is a devastating condition. When prices rise faster than wages, a consumer’s standard of living drops because goods become expensive. In this type of environment, manufacturing slows down, workers are laid off, and a downward spiral of the economy begins.  In this environment, a company’s stock value would tend to decrease.

Summary

Inflation per se is not bad. Mild inflation is actually good for the growth of the overall economy. However, inflation is a problem when it becomes too high or too low.  Extreme inflation may impact your investment portfolio and, in turn, your future financial security.