Inflation: How it Works and How to Beat It
There has been a lot of finger-pointing regarding the inflationary surge that took place following the onset of the COVID-19 outbreak. Republicans blame Democrats and Democrats blame Republicans.
This article aims to shed light on the key factors behind the surge in inflation since 2020 and its implications for various stakeholders. But first, what exactly is inflation?
What Is Inflation?
Inflation is a sustained increase in the general level of prices for goods and services in an economy over time. It means that, on average, prices are rising, and the purchasing power of money is decreasing.
Mild inflation can indicate a healthy economy, as it encourages spending and investment. However, high inflation can erode the value of savings, reduce purchasing power, and create economic instability.
Central banks and policymakers aim to manage inflation by implementing monetary and fiscal policies, such as adjusting interest rates or controlling government spending, to maintain price stability and promote sustainable economic growth.
Here are the most important factors that have driven inflation in the past three years.
The COVID-19 pandemic and the subsequent lockdown measures implemented worldwide in 2020 disrupted supply chains and caused a sharp decline in economic activity. For example, oil production plummeted in the spring of 2020, and has yet to recover to pre-pandemic levels.
As economies gradually reopened, the rapid recovery fueled pent-up demand, resulting in increased spending. However, the sudden surge in demand outpaced the capacity of supply chains, leading to supply shortages and higher prices for goods and services.
Fiscal Stimulus and Monetary Policies
To counter the economic downturn triggered by the pandemic, governments implemented expansive fiscal stimulus packages and central banks pursued accommodative monetary policies.
These measures injected massive amounts of liquidity into the economy, supporting spending and investment. However, the excess liquidity, combined with supply chain bottlenecks, has contributed to inflationary pressures.
Commodity Price Volatility
Another crucial factor contributing to inflation has been the volatility in commodity prices. The disruption of global supply chains, coupled with increased demand from recovering economies, led to significant price fluctuations in commodities such as oil, metals, and agricultural products.
Higher commodity prices have cascading effects on production costs, transportation expenses, and ultimately, consumer prices, amplifying inflationary pressures.
Labor Market Dynamics
The labor market also plays a role in the inflation surge. The pandemic-induced disruptions, coupled with labor shortages, have pushed up wages in some sectors, particularly those reliant on low-skilled workers. Rising labor costs are often passed on to consumers through higher prices, further exacerbating inflationary pressures.
Inflation Expectations and Behavioral Factors
Expectations of future inflation can become self-fulfilling prophecies. As consumers and businesses anticipate rising prices, they may adjust their behavior accordingly. This can include hoarding goods, demanding higher wages, or increasing prices in anticipation of future inflation. Such behavioral responses can contribute to a spiral of rising prices, amplifying inflationary pressures beyond the initial supply-demand imbalances.
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The surge in inflation since 2020 can be attributed to a combination of pandemic-induced disruptions, expansive fiscal stimulus, accommodative monetary policies, commodity price volatility, labor market dynamics, and inflation expectations. It is important for policymakers to carefully monitor these factors and implement appropriate measures to manage inflation and maintain economic stability.
Investing for Inflation
Your goal as an investor is to stay ahead of inflation. When inflation heats up, your returns need to improve, or the purchasing power of your portfolio will decline. If your money is parked in a low- or no-interest savings account, in 10 years it can lose 20% of its purchasing power even in a low-inflation environment.
You should have at least a portion of your portfolio in inflation hedges. These are assets that perform well in an inflationary environment. Some examples are gold, real estate, and commodities. More risk-averse investors should consider Treasury inflation-protected securities (TIPS), which are U.S. Treasury bonds that are indexed to inflation.
Finally, certain stock sectors are better for protecting against inflation. Some examples are the sectors that make the goods that are in high demand, and hence helping to drive inflation, or that provide the raw materials for these sectors. Popular inflation hedges include real estate investment trusts (REITs), gold stocks, energy stocks, and basic materials.
The most detrimental approach in the long run is taking no action to protect against inflation. Allowing your money to sit in a low-interest account is a strategy that ultimately leads to financial losses over time.
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