How Inflation Works

Inflation has been the big topic of conversation this week. The US Congress just passed a 1.9T spending bill to help the US economy. The way we are going to pay for this stimulus is with a lot of new US debt. And so everyone is concerned that this will cause inflation. On Wednesday, the Federal Reserve Chairman Jerome Powell testified that they have inflation under control, and that they have tools to deal with it. I wanted to make a video to put this conversation in context and explain how inflation works. WATCH NOW






Let us start with an important concept on inflation. Inflation can occur naturally. This is important to keep in mind, because when a lot of people talk about inflation, they talk about it in the context of inflation being a man-made phenomenon. It does not have to be. Inflation is actually a normal part of economics. Inflation means an increase in prices, which is driven by supply and demand. For example, imagine a scenario where the world is coming out of a global pandemic, and there is a lot of pent up demand to travel. The change in supply and demand is going to inflate travel prices.

In general, a better economy will lead people to spend more money, which inflates prices. A worse economy makes people more hesitant to spend money, which deflates prices. That is a very simplistic explanation, and there is a lot more that goes into it. But I am just trying to explain the basic concept.

You will most often hear about inflation in discussions about central banks. The purpose of a central bank is to manage inflation of a country. They do this by printing money. The idea is that you can smooth out the natural economic force of inflation by increasing or decreasing the money supply. A stable currency is good for everybody. There are some people who argue, that central banks are doing a bad job. They will argue that fiat money is bad, and printing money is bad. But I am not tackling those questions in this video. What we can all agree on is that inflation will always exist in some form, and central banks are trying to manage it.

A common question people ask is why don’t we just get rid of inflation altogether? There is a concept that you have to keep in mind. Inflation creates BOTH good and bad results. The bad results are obvious because it is reducing the value of your money. If you have $1,000, and inflation happens, over time as prices increase, you will be able to buy less and less with that $1,000. But why is inflation good? Small amounts of inflation encourage growth. Let us go back to our example. If you have $1,000, and you know inflation is going to destroy its value, you will be incentivized to put that $1,000 to work to try and make it grow to keep pace with inflation as opposed to just saving it in your bank account. The choice is whether to retire and live off your savings or work and try to better yourself. Inflation incentivizes everyone in society to work, and that is a good thing. It is like we are all on this endless treadmill of work that never stops, and if you cannot keep up, you become obsolete, and all your money becomes worthless. That is how economics works.

Let me put it another way. You have desires. You have things you want in life. You want to travel, start a family, own a home. Those things cost money. You want to be surrounded by opportunities to get a job and make money, to better yourself and the people you care about. Slow, steady, inflation makes it easier to achieve opportunities, than if we had no inflation.

Going back to my earlier point, inflation is a natural economic phenomenon. So whether we had central banks or not, we would still deal with inflation, it just would not be managed by anybody. The reason we would still deal with inflation, is because it is part of what makes us human. Like I said before, you all have desires about what you want to accomplish in life. If you look at the entire history of humanity, it is this epic story of humans continually trying to improve their situation. That is one of the defining characteristics that makes us human. Those desires turn into market transactions that will impact supply and demand. The endless treadmill of work that never stops exists because we are human. Inflation is the natural representation of humanity’s desire to improve ourselves.

So what do we do about this? We are sitting here today, and congress is passing a 1.9T stimulus bill, and they are going to print a whole lot of money. Is this a good thing? This gets into economic policy. The important thing to keep in mind when you talk about economic policy is that economic policies can hurt one group while benefiting another.

A lot of discussions around economic policy, end up being different groups of people fighting for what benefits them the most. The people who hate inflation the most are old people, because they are on a fixed income. Imagine if you were to retire, and your income is set at 50,000/yr for the rest of your life. Every year you see your rent go up. Every year you see food prices go up. So every year, you become more and more poor and there is nothing you can do about it, because you are retired and there is no way you can earn more money. So older people as a group advocate against inflationary economic policy in order to preserve their wealth. Well if society tries to eliminate inflation to benefit old people, it is at the expense of young people. You are taking away money from young people, and giving it to older generations. Young people want economic opportunities. They want to find a job. Inflation does not affect them as much because if prices increase, they can just get a raise, or find a different job that pays more. Additionally, if a young person has a lot of student loans, inflation is good because as the value of your fixed payments decrease, it makes it easier to pay them off. Someone else who also benefits from inflation is businesses, because they can just keep raising prices. Now not all businesses can raise their prices as easily as others, but we are talking in generalities. Another example is that many businesses owe huge liabilities for pension payments to their retired employees. Businesses benefit by destroying the value of what they owe through inflation. When businesses do better, they can hire more young people and the economy does better.

I am not saying that one approach to inflation is better than the other. I am not saying that one group of people is better than the other. I am saying that with big economic decisions, you need to understand everyone’s agenda. That is why economic policy is so difficult. There is no one best economic policy, because it depends on who’s perspective you are looking at. What is important for you watching this video today, is that you understand what is going on with inflation, because you want to make the best financial decision to protect your own financial situation.

Another concept that everyone agrees on is that hyperinflation is bad. A little bit of inflation may be good for some people, but if inflation gets too high, it is bad for everybody. If you look at business history, in every example we have seen hyperinflation leads to social unrest, the most obvious example being hyperinflation in Germany before World War II broke out. The US Federal Reserve has discussed many times that they want to avoid hyperinflation.

Let us look at the situation today. Jerome Powell is the chairman of the US Federal Reserve. He has this difficult task of setting policy, and printing money in an attempt to manage inflation. He does not want too much inflation or too little inflation. Let me show you what he is looking at. [chart] One tool the Federal Reserve has used to manage inflation is the Fed Funds rate. When inflation is high, the Fed can raise rates, which reduces the money in the system, and reduces inflation. This chart goes back to 1954, and you can see historically we have had huge spikes in the Fed Funds rate, most notably in the 70s and 80s, in order to fight inflation. You can also see that in recent times, we are at historically low rates. The US has had so many recessions in the last two decades, that deflation has been a bigger concern than inflation. Since the US is struggling with a recession because of the health crisis, deflation is still more of an issue right now than inflation. Jerome Powell is looking at this chart, and saying that inflation is not his biggest concern right now, and that if it becomes a concern, they have tools to address it, like raising rates.

One of my takeaways from this chart is that in recent years, we have been seeing downward pressure on inflation from US demographics. In the US, baby boomers are retiring which is a large percentage of the work force. I described before how inflation is driven by the choice of looking at your money and deciding whether to work, or live off your savings. People in retirement do not spend as much money as people who are working and raising a family, and the drop in demand lowers prices. When a large amount of society is switching to live on fixed incomes, that will put downward pressure on inflation. And this downward pressure will likely continue for some time. One of the issues with this, is the US dollar has become the reserve currency of the world. And so now, the issues with US demographics is now affecting the entire world.

Let me just end with a few closing thoughts:

  • The US economy is in rough shape
  • The US Federal Reserve is doing their best to manage inflation
  • It might take some time, but I am confident that the US can work through this
  • If the US Federal Reserve does the right things, we will see a strong economy and a strong US dollar

Leave a comment down below letting me know what you think!

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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.

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