“Stocks dip, extending last week’s declines as inflation jitters linger.”
Yahoo Finance Headline
The headline above appeared on the Yahoo Finance homepage on Monday, May 17th. Inflation has been consistently in the news these past few weeks. Its mention is almost always accompanied with the word fear or some synonym (as above.) We have all heard and read the word inflation. But what does it mean? What is there to fear, and perhaps most importantly, what can we do about it?
I am going to do my best to provide you a clear, simple, jargon free explanation of inflation and an answer to these important questions. I hasten to add that this is not intended to be, and should not be considered, comprehensive. It is just a plain language breakdown of a term that I believe is stated a lot more often than it is understood.
Let us start with a definition. Since big words tend to make understanding less and not more likely, I prefer using working definitions. Here are a couple.
Inflation:
- Your money buys less than it did before
Or
- Higher prices
Pretty simple, right? But what is it about inflation that causes prices to go higher? The answer is slightly more complex, but not much.
Governments, in concert with central banks like the Federal Reserve, which is the de facto central bank of the U.S., engage in what is broadly called “monetary policy.” By raising or lowering interest rates and expanding or contracting the money supply, they seek to create or maintain a kind of goldilocks economy. One that is neither growing too fast nor too slow but, like the porridge of our bedtime stories, is just right.
The way money is added to the money supply is also straight forward. The US Government borrows money through the issuance of government bonds. The government pays interest to the bondholders in exchange for borrowing their money. Each bond has a maturity date. That is, the date they promise to pay the borrowed money back, typically, after a period of 1,10, 20, or 30 years. Generally, the longer the period of time, the higher the interest paid.
This is the part where things get a bit weird, so stay with me. Often, the bonds will be purchased by the Federal Reserve (Fed.) That is, the Fed will lend the government the money it needs.
Where does the Fed get the money? They type a number into a computer.
No really, it is that simple. They create the money and basically just enter an IOU in a ledger.
That is what Nobel Prize winning economist Milton Freidman meant when he said, “Inflation is everywhere a monetary phenomenon.” Inflation is created by governments and their monetary policies. Specifically, the policies which create (print) more money out of thin air.
But why do prices go higher simply because there are more dollars? Economists say there are two basic types of inflation. They call them cost-push and demand-pull inflation. Both are functions of that most basic economic concept, supply and demand.
The more of whatever commodity we have, wheat, fuel, sugar, dollars, the less expensive it becomes. The less of it available, the more expensive it generally gets. Gold is expensive, air is free. I find it easier, however, to think of it in less abstract terms.
Some of you may recall the popular 80’s television show “Little House of the Prairie.” I preferred cartoons and sports, but I have five sisters and we had only one TV, so I frequently watched that show. Anyway, people on the show often engaged in business transactions via trade or, barter.
Let us imagine that we are on that prairie, grow lots of apples and a neighboring farm has plenty of grain. We may work out an arraignment where we trade some of our apples for some of their grain. We might also do this with other farmers for other commodities like corn, beef etc.
After a couple of years of this arraignment we notice that we are receiving less grain in exchange for our apples. We are getting less for our money.
We mention this to our grain farmer who explains that her costs have gone up. Perhaps it is owing to tariffs, taxes, labor rates, equipment, or any combination of reasons. So, she had to offset those production cost increases by raising the price of her grain.
Since our costs have now gone up, we seek to offset that by raising the price of our apples, thereby raising prices for everyone who buys (trades for) our apples. Price increases, like ripples on a lake, cascade through the economy of the prairie. Everyone raises prices to offset the rise in prices. That is cost-push inflation. Higher costs are pushing prices higher.
In a slight shift, lets us now imagine that a small city is becoming a big city near our house on the prairie. Big cities usually have lots of mouths to feed and generally do not grow a lot of food. Demand for our apples, and the products of our neighbors’ farms, explodes.
Suddenly, there are lots of dollars chasing too few apples. Consequently, we must raise prices to offset demand and to increase production to meet it. This is demand pull inflation. The demand for things gets ahead of supply and pulls prices higher to satisfy it.
The government contributes to creating both types of inflation by increasing costs on businesses through taxes, mandates and regulation (cost-push) and by flooding markets with newly created dollars for folks to spend (demand-pull.) Hopefully, this super basic breakdown has provided some of you with a better understanding of inflation and its causes.
Now for the million-dollar question (a billion-question adjusted for inflation.) What can be done about it?
I have great news for you. While there is no single thing we can do that will entirely ameliorate, that is, make better, our inflation situation. There are, however, many small things we can do that can make a significant impact on our financial well-being.
First, second and third, save more. Think about it, no matter what happens in the future, the people who are saving more will be better off.
Fourth, diversify. And not simply by having a bunch of mutual funds with different names but mostly the same underlying assets. There are assets and asset classes that have a history of performing well in inflationary periods. Do you know what they are? Do you possess them? Knowledge is power. Would you like to learn more?
If you would like to do what can be done in an effort to protect yourself, your business and those you love from what might be an oncoming inflation train, or you would like to work out a convenient and sensible plan to save more, or both, speak with a financial planner who has earned your confidence.
We can choose to live by design or default. I believe design is better. Act now!
Scott R. McGimpsey May 31st , 2021
This material was prepared by Scott McGimpsey and does not necessarily represent the views of the presenting party, nor their affiliates. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Neither Cetera Advisor Networks LLC nor Scott McGimpsey is engaged in rendering legal, accounting, or other professionally services. If such assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any federal, state, or municipal tax penalty. Moreover, a diversified portfolio does not assure a profit or assure protection against loss in a declining market.