Understanding Inflation: Causes and Hedges
As the COVID-19 pandemic winds down, people and businesses have been trying to get back to normal. At the same time, we’ve had increased government spending, a war in Ukraine, and delays in the supply chain, a term many of us didn’t know a few months ago.
All of this has led to an environment of significant inflation. Although we think of inflation as things costing more money, technically, inflation is a decrease in purchasing power. In other words, it’s the idea that one dollar won’t get you as much as it used to. For example, there was a time when gas would cost a dollar a gallon. But thanks to inflation, a dollar will only get you a fraction of a gallon today. It’s the same concept, just thought of in a different way.
What Causes Inflation?
Many people associate the cause of inflation with rising prices elsewhere in the system. The idea being that if it costs more to create something, retailers have to pass on that increase to consumers. For instance, imagine that you sell light bulbs. It costs you fifty cents per bulb and you charge your customers $1.50 per bulb. If your suppliers suddenly start charging you a dollar per bulb, you’ll likely have to pass on that extra cost to your customers, upping your sales price from $1.50 to $2.00.
But that doesn’t get to the real issue. If we consider inflation to be rising prices, then how can the cause of rising prices be rising prices? The more important question is what caused the price of the light bulb to increase in the first place? That is, why did the supplier start charging more? The short answer is supply and demand, but maybe not in the way that you’d assume.
Prior to 1971, US dollars were backed by gold reserves. That means that each dollar in circulation was connected to a certain amount of physical gold. But in the summer of 1971, President Richard Nixon took the United States off the gold standard. Now we can have as many dollars in circulation as we want and citizens can no longer exchange cash for precious metals, like gold and silver.
The US Dollar used to be respected worldwide as the most secure and stable currency because those dollars were connected to something tangible. But that’s no longer the case. A dollar today only has value in the sense that others value it. It has value simply because people accept it and consider it valuable. If in the future people decide that they don’t want dollars any longer and they instead want cryptocurrency or even something random like sea shells, then dollar bills could become worthless. Gold and silver have historically always had value because they’re a finite resource. You can print dollars, but you can’t print gold.
Nowadays, when the United States needs more money, it simply has more printed, and it’s the printing of money that’s the real cause of inflation. Let me explain with an example.
Since each person only has a fixed amount of money, they have to make decisions about what to buy and what not to buy. If two people want the same item, the person willing to pay more generally gets it. When we extend that idea to a large number of people, we deem this process supply and demand.
Supply and demand determine prices in a marketplace (when there are lots of buyers and sellers). For example, if lots of people want something and there’s only so much to go around, prices go up. Think back to 2020 when people couldn’t get toilet paper and those who could find it, were turning around and selling it online for ridiculous prices. The same thing is happening now in the Spring of 2022 with baby formula. With so little of it to go around, desperate parents are willing to pay higher prices.
Each person has a limit though. There is an amount at which a person either won’t or simply can’t pay more no matter much they want something. But what if you had more money? Well naturally if you had more money then you could afford to spend more. So, imagine if your limit for an item was $20, but then you were given a big raise. Now, maybe you’re willing and able to spend a more for the same item.
A stimulus check would work the same way, except that it pertains to everyone and not just one person. In this case, each person would now have more money to spend on the things they want and need. While this sounds nice on an individual level (everyone would like to be able to afford more stuff), it affects supply and demand. Before the demand for an item kept the price around $20, but if everyone suddenly has more money then everyone can bid more for something in short supply. This raises the price, so that what used to cost $20, now costs $25.
Thus, inflation stems from an increase in the supply of money. Between government stimulus checks and government spending that puts more money into circulation, we have more money available to go around. It’s that increase in available money that leads to inflation and rising prices. When the government spends money supporting a war, on needed infrastructure improvements, or any cause, no matter how important, it typically adds money into the system. That is, unless it comes from money the government has already saved up, the government creates new money in order to pay for these things. Even if you don’t personally see any more of that money, it’s still there.
If the government spends money on buses to get refugees out of harm’s way that money is going to the companies who transport the refugees. I’m not arguing that we shouldn’t help refugees. I’m simply making the point that more money can enter circulation even if you don’t personally see it. You may not have gotten a raise, but refugee transportation companies now have more money that they can spend on things they want, essentially competing with you and bidding up prices. You need gas for your car and they need it to operate the buses that transport the refugees. Thus, whether you realize it or not, you’re competing for a limited supply of gas, and raising its price in the process.
A Hedge Against Inflation
People often say that certain investments such as real estate can be a “hedge against inflation”. Have you ever wondered what that means? A “hedge” is simply an investment made with the intention of reducing risk.
When we think of inflation, it’s a form of risk. If you don’t invest your money today and earn interest on it, that money will buy you less in the future because of inflation. Thus, keeping your money in a non-interest-bearing savings account has risk.
When you invest in real estate and specifically income producing properties though, you have some protection against inflation. Let’s say that you own an apartment complex. You charge tenants rent, pay your expenses, and pocket the difference as profit. But what happens when there’s inflation and your expenses go up? When there’s inflation, rents go up too. Because rents go up at the same time that expenses go up, your profit is protected.
While not everyone can afford to own an apartment complex, owning shares of real estate companies such as through REITs or private funds that invest in real estate can provide the same type of protection against inflation.
Another Semester Ends
As this academic year comes to a close, it seems as good a time as any for a little reflection. This week I just completed the second of four semesters towards earning my MSRE (Master’s of Science in Real Estate). If you’re not familiar with an MSRE degree or contemplating a degree in real estate, check out my earlier article.
In many ways it was both a long and a short year. It went quick, but the year was also packed with classes, assignments, projects, interviews, property tours, and at times fun spent with my classmates.
The program I enrolled in uses a cohort system, where instead of selecting your own courses, you go through a prescribed sequence of courses. One of the effects of this is that you’re in each of the same classes with the same people (with a few exceptions). As a result, while there’s less flexibility in your schedule and the courses you take, you have the opportunity to work closely with the same people in not just one, but all of your courses. This means you get to know each other that much better than if you only saw someone in one or maybe two classes.
We each have our own unique skills, strengths, and weaknesses. We each have our own backgrounds and past experiences. Knowing this makes it easy to know who to go to when you have a question. It also makes splitting up group assignments easier because we already know that while one person is great at financial projections, another person shines when it comes to creativity, writing, research, or has connections with people in the arena of sustainability or law, etc.
I’ve really enjoyed getting to know the people in my cohort and sincerely hope that we’ll all stay in touch and remain friends for years to come. You know who you are. Thanks for great year!