Friday, February 11, 2011, AM | 5 Comments
I am reading a book about finance and economy and it makes some interesting points about inflation. If I understand it correctly, inflation is not just an increase in prices, but it is a symptom of excess money and credit in the national economy. I always thought and I hope millions of folks thought too the “normal” definition of inflation which is an increase in prices. That’s the definition I had learned the day I first heard the word.
I don’t want to be alone in the world to misunderstand inflation. However, that definition is definitely not wrong either. But it is just a symptom of state of the economy today what went on yesterday.
In the United States, the Federal Reserve Bank is the only entity that can control inflation by raising interest rate better know as discount rate. To control the flow of credit (that’s money in the long run) in the economy, the Fed raises discount rate to make it harder for organizations and individuals to get credit (loan).
When more money or credit is available, it is invested in production and expansion of products. More jobs are created. Folks have more money. They spend more. The prices almost always increase and that in turn creates what is known as inflation.
The Two Stages of Inflation
Inflation is a process that happens in two stages:
- It begins with an increase in money and credit above what is needed for the production of goods and services.
- Rising prices is actually a consequence of the first stage. Consumers see and feel the second stage only.
The Two Types of Inflation
Inflation has basically two types:
- The first type affects materials we consume on a daily basis. For example food, filling up our auto gas tanks etc. This is usually measured by Consumer Price Index. CPI indicates whether there is a general rise in cost of living. A rise in CPI creates a feel-bad atmosphere for most of the populace who almost always have no choice but to take part in it.
- Inflation can also raise prices of assets we own. For example, homes, stocks, bonds, gold, silver, and foreign currency. A rise in asset prices creates a feel-good atmosphere for those who have taken part in acquiring assets.
Both types of inflation do not necessarily go hand in hand. Price of assets can go high while that of daily consumption can go lower or vice versa. For example, housing market is still down, unemployment is still quite high. But other assets like precious metals – gold and silver – are way up while the inflation as we – the consumers – know it is still low.
Investors better watch out
For investors, it’s important to understand not only both stages of inflation but both types of inflation as well. Some investors might get into panic mode when they see lowering CPI and start selling while the asset type of inflation may be rising. That’s considered a big mistake when assets are sold in panic.
Inflation can ultimately become deflation because it leads to too much debt, overpriced financial assets, and excessive investment in housing, commercial buildings, and industrial capacity.
Investors ought to understand the different impacts that excess money and credit can have on the two types of inflation. They must understand how to benefit from either type. By the way, assets inflation turned out to be more dangerous and was mostly ignored by the Fed before the beginning of the recent Worst Recession whereas they concentrated much of their attention on CPI. It seems almost a conspiracy against the POD Group.
The stock market is one place investors can bet on. There is a higher probability the bear market that began in 2000 bottomed out in spring of 2009. Since then, on and off, it has been mostly on the rise. Careful investment can generate decent returns while keeping risk at tolerable levels.
Investors unfortunately must deal with the real world and its greatly elevated risk and uncertainty. I will leave the rest of the discussion to your financial adviser when you meet next time.
In a Nutshell
Central bank in a country controls the creation of money and to a lesser extent credit. When there is either type of inflation, we must understand there is always the central bank working behind the curtain.