What is Inflation and What Causes It? [Ultimate Guide]

Summary: In this article, you’ll get answers to the questions what is inflation and what causes it. Additional topics included in this article are how inflation is measured, types of inflation and its effects, the best investments to protect yourself and how to fight inflation through real estate investing.

THE VALUE OF A DOLLAR

The ongoing fight against inflation continues as more and more American’s struggle to stretch their income to meet the increasing cost of living. With the dollar losing value, $100 today isn’t worth nearly as much as it was 20 years ago. So how will American’s adapt to the rising cost of living while maintaining the same standard of living? We’ll break down the impact of inflation and the best investments to protect yourself from inflation, and even profit from it.

WHAT IS INFLATION?

Inflation in economics is the increase in the prices of goods and services over time. Basically, it means that it costs more today to buy a loaf of bread, fill up your gas tank or hire a babysitter than it did five or 10 years ago.

In the United States, inflation decreases the purchasing power or value of the dollar. Money buys less when prices rise, raising the cost of living and lowering the standard of living over time.

Because inflation impacts the value of money as well as the prices of goods and services, understanding its causes and effects can help investors adjust and even profit through smart, inflation-fighting investments.

WHAT IS INFLATION RATE?

Inflation rate is how much prices increase or decrease during a specific period of time – usually every month or year. The percentage shows the rate in which prices rose or fell.

For example, let’s assume the inflation rate for a gallon of gas is two percent a year. If a gallon of gas costs $3.00 today, next year it will cost $3.04 and so on.

Inflation rate and unemployment rate are the two main components of what’s known as the misery index. (Unemployment rate measures the “misery” of people being laid off and unable to find jobs.) An index that is higher than 10% means that people are suffering from a recession, galloping inflation, or both. More on that later…

WHAT CAUSES INFLATION

The two causes of inflation are demand-pull inflation, the most common, and cost-push inflation, which is less common. There are a number of economic factors that impact these two causes of inflation, which I’ll explain in the following sections.

Demand-Pull Inflation

Demand-pull inflation is due to high consumer demand for a product or service. When there’s a spike in demand for goods in the economy, prices go up and demand-pull inflation occurs. When unemployment rates are low and wages are increasing, consumers tend to spend more money and save less. An expanding economy directly impacts consumer spending, leading to a rising demand for products and services. The basic economic principle of supply and demand states that as demand increases, supply decreases. Higher prices are caused by demand-pull inflation.

5 Contributors of Demand-Pull Inflation

A Growing Economy. A strong and expanding economy usually means that people can get better jobs, make more money and thus spend more.
Expected / Built-In Inflation. Rising prices causes consumers to expect inflation. Consumers may choose to spend more now instead of in the future, to avoid higher costs. Expected or built-in inflation boosts economic growth even more.
Discretionary Fiscal Policy. Inflation is impacted when the government spends more or taxes less.
Marketing and New Technology. Specialty products or asset classes from marketing and new technology can result in asset inflation. This type of inflation results in price increases across the board.
Excess of Money Supply. The money supply increases through either expansionary fiscal policy or expansionary monetary policy. The money supply not only includes cash, but also debt such as credit, loans and mortgages. When the U.S. dollar decreases in value, relative to foreign currencies, the prices of imports goes up and thus prices in the total economy.

Cost-Push Inflation

On the other side of the coin, cost-push inflation is caused by a lack of supply. When prices in production costs increase, like wages and raw materials, the result is cost-push inflation. During this type of inflation, the supply of goods decreases, while demand stays the same. The producer or seller then has the power to raise prices for consumers.

For instance, if the cost of raw materials like oil increases, those added costs are passed on to the consumer to adjust to cost-push inflation.

The single biggest expense for businesses is usually wages paid to employees. When unemployment rates are low, it forces businesses to increase wages in order to attract qualified candidates to hire.

Another factor that can cause cost-push inflation is a natural disaster. If a tornado tears through a large corn-producing area destroying supply, prices around the country will go up, as the demand remains high.

5 Contributors of Cost-Push Inflation:

Wage Inflation. Increased salaries due to a low unemployment rate.
Monopolies. When a company monopolizes an entire supply of a good or service, they have complete control over how much to charge consumers. (The Sherman Anti-Trust Act outlawed monopolistic business practices in 1890)
The Depletion of Natural Resources. Natural disasters may cause temporary cost-push inflation by destroying production facilities.
Government Regulation and Taxation. U.S. tariffs can also decrease supplies.
Currency’s Exchange Rates. When currency’s exchange rates are lowered, it triggers cost-push inflation on imports, making foreign goods more expensive than local or domestic goods.

How is Inflation Measured?

There are a number of ways to measure the inflation rate. Economic experts refer to the following indexes in order to keep an eye on the current rate of inflation and where it might be headed.

Consumer Price Index (CPI)

The CPI or Consumer Price Index measures prices for goods and services in an economy. This includes food, cars, education and recreation.

Producer Price Index (PPI)

The PPI or Producer Price Index illustrates changes in prices that affect domestic or local producers. PPI keeps track of prices for fuel, farm products, chemical products and metals.

Calculating Inflation Rate

There are plenty of inflation rate calculators out there. However, it’s always a good idea to understand what indexes are being used to calculate inflation rates and why. The rise in Inflation = (Final CPI Index Value/Initial CPI Value)

Using the formula above, let’s figure out what the purchasing power will be for $10,000 from 1975 to 2018. The CPI index in 1975 was 54.6 (Initial CPI Value) and 257.346 (Final CPI Value) in October 2019. Now, let’s plug in the index data to our formula:

The rise in inflation = (257.346 / 54.6) = 4.7132 = 471.32%

To find out how much $10,000 is worth in 2019 compared to 1975, multiply the rise in inflation with the amount to get a dollar value:

Change in dollar value = 4.7132 x $10,000 = 47,132.96

Now add the original amount of $10,000 to the change in dollar value:

Final dollar value = $10,000 + $47,132.96 = $57,132.96.

Finally, your $10,000 in 1975 would now be worth $57,132.96 in 2019 due to inflation.

TYPES OF INFLATION

There are many different types of inflation. The four main types are classified by speed, which are creeping, walking, galloping and hyperinflation. There are also types of asset inflation and wage inflation.

Creeping Inflation

Creeping inflation is also known as mild inflation, this occurs when prices rise 3 percent a year or less. This causes consumers to expect prices to continue rising, which boosts demand for consumers to buy now instead of later when the product will likely be more expensive.

Walking Inflation

Walking inflation occurs when prices rise 3 to 10 percent a year. Walking inflation is bad for the economy because it ignites growth that is too fast. Consumers tend to stock up on products in order to avoid quickly rising prices, driving demand so high that supply can’t keep up. Wages can’t keep up either and ordinary goods and services are too expensive for the majority of consumers.

Galloping Inflation

Galloping inflation is when inflation is 10 percent or more. When this type of inflation happens the overall economy suffers greatly. The value of money drops so quickly that businesses and wages aren’t able to keep up with prices. Galloping inflation results in an unstable economy and foreign investors take their resources elsewhere.

Hyperinflation

Hyperinflation occurs when prices soar to 50 percent or more a month. This type of inflation is rare and has only happened in the U.S. once during the Civil War.

Core Inflation

Core inflation measures the increasing prices of everything except food and energy. Because the Fed does not want to adjust interest rates along with gas prices, they use the core inflation rate to help set monetary policy. Note: Core inflation rate doesn’t include energy and food prices because they are set by commodities traders and are too unstable to consider.

Deflation

The opposite of inflation, deflation is when prices drop. Another term used to describe deflation is when an asset bubble bursts. Deflation is much harder to stop than inflation and can turn a recession into a depression.

Wage Inflation

When wages increase faster than the cost of living, it’s called wage inflation. This can happen if 1) there is a shortage of workers, 2) labor unions negotiate higher wages, and 3) workers control their own pay.

Asset Inflation

Also known as an asset bubble, asset inflation happens in one specific asset class. Examples of asset inflation by classes include gas, oil, food, gold and housing.

Methods to Control Inflation

Central banks use monetary policy as their main way to control inflation and avoid deflation. The target inflation rate set by the Feds is 2 percent year-over-year in the U.S. This inflation rate has proven to support a healthy economy.

While inflation is mostly controlled by the Central Bank and/or government, there are different methods to help control it. I’ll briefly explain each method next and go into more detail later in the article.

5 Tools to Control Inflation

Monetary Policy. Setting interest rates. Higher interest rates lower demand, which leads to lower growth in the economy and lower inflation.
Control of Money Supply. Monetary policy experts say there is a connection between the money supply and inflation. Thus controlling money supply can control inflation.
Supply-Side Policies. Certain policies will improve the competitiveness and efficiency of the economy. In turn, pushing long-term costs down.
Fiscal Policy. Increasing the rate of income tax can result in less spending and reduce inflationary pressures.
Wage Controls. In theory, attempting to control wages could help decrease inflationary pressures, however, it’s rarely used.

The Effects of Inflation

A little inflation is good for the economy. As stated previously, the Federal Reserve tries to keep inflation rates around 2 percent annually. This helps keep the economy from getting too hot, causing a bubble burst. By doing so, consumers are able to maintain their purchasing power and standard of living.

Positive Effects

Encourages Spending and Investing. Predictably, when inflation causes the value of money to decrease, consumers tend to start spending and investing now, so that they won’t continue losing value as prices rise.
Reduces Unemployment. There is some indication showing that inflation reduces unemployment. Income tends to change much more slowly when the economy shifts. The idea is that as unemployment goes down, employers are then forced to pay more in wages in order to hire the necessary skilled workers. (Refer to cost-push inflation)

Negative Effects

Decreases Purchasing Power. As prices rise across the economy, overall buying power goes down as money loses value.
More Inflation. When consumers and businesses start to spend and invest more and more money now, in an effort to combat depreciating currency, it usually causes more inflation. In turn, the price of money drops at an even faster rate.
Increases the Cost of Borrowing. Low interest rates allow more individuals and businesses to borrow money on the cheap. This encourages spending and investing, which boosts the economy, but it also boosts inflation. These low interest rates must increase at some point, making the cost of borrowing high. Think of it as a tug-of-war between inflation and interest rates to keep inflation at a healthy 2 percent.

How Does Inflation Affect Interest Rates?

The Federal Reserve is responsible for keeping inflation low and supporting high employment rates. Basically, the Fed tries to keep unemployment as low as possible without triggering a rise in inflation. When interest rates for bank loans is low, consumers and businesses are able to secure cheaper loans, in turn boosting the economy.

On the other hand, when the Fed increases interest rates, economic growth slows as the cost of borrowing goes up. So why would the Feds want to slow down growth? Again, it goes back to the goal of balancing inflation with employment. When the economy gets too hot, inflation rises and so does the chance of a recession.

The Best Investments for Inflation Protection

Wondering how to protect yourself from inflation? While one asset won’t beat inflation all of the time, certain investments do better than others. Know how to protect yourself and your assets during an inflationary climate.

Increase Your Income

The best way to protect yourself from inflation is to make more money. If you can get an annual raise or promotion that nets a 20 percent gain, inflation won’t impact you. However, if you’re on a fixed-income and don’t have the option to make more money at your current job, consider other options.

Invest in the Stock Market

A great way to protect your savings is to invest in the stock market. While there’s always a risk, long-term returns are historically about 10 percent. The key to investing in the stock market is to take a long-term approach and resist pulling your money out when the market dips. History has shown that it will always bounce back sooner or later.

Invest in Protected Securities

Looking for an even safer way to protect yourself and your assets from inflation? The U.S. Treasury offers two good options. Treasury Inflated Protected Securities or TIPS pay a fixed rate of interest and beats inflation 80 percent of the time. The government adjusts the principal investment twice a year depending on changes in the Consumer Price Index or CPI.

The value of the bond rises as inflation rises. While the interest rate stays the same, investors get a larger return as the percent is applied to a growing principal. Keep in mind that TIPS perform better during times of inflation and worse during stability or non-inflation. However, holding the bonds or securities long-term should give you comparable returns to a diversified portfolio, including stocks.

Invest in Series I Bonds

The second safest investment option offered by the U.S. Treasury is Series I Bonds. These bonds come with a guaranteed fixed rate of return. Like TIPS, it’s impacted by a variable rate according to the CPI and is reset semi-annually.

Investor returns on a Series I Bond is a combination of the fixed rate and the variable rate at that time.

Invest in Leveraged Loans

A leveraged loan is offered to companies or individuals that currently have a good amount of debt and/or bad credit history. Leveraged loans typically come with much higher interest rates, making it costly to borrow. However, they outpace inflation 79% of the time.

Invest in Real Estate

Real estate income surpasses inflation 71% of the time. Real estate investment trusts (REITs) allow investors to buy equity in real estate projects. REITs beat inflation 69% of the time. Next I’ll explain how to fight inflation by investing in real estate.

How to Fight Inflation Through Real Estate Investing

Now that we know what inflation is and how it works, let’s use the following example to illustrate the power of inflation–but in a good way. If you bought a house in 1995 for $200,000, fast forward to 2019 and that house would cost around $400,000. And this amount doesn’t even include how much the home has appreciated. Inflation makes the same asset worth more money over time. So how do you fight inflation and even profit from it? By investing in real estate. There are three components that make real estate an excellent way to not only keep up with inflation, but use it to your advantage.

1 - Appreciating Value

One beautiful thing about owning a real estate asset is appreciation. According to Zillow, property values appreciate on average between 3 percent and 5 percent annually. In certain markets appreciation rates are even higher, between 6 percent and 10 percent, varying by year. To help drive home the power of appreciation, let’s say you buy a house for $100,000. With an annual appreciation rate of 5 percent, in only 10 years your property would be worth $150,000. Now let’s compare appreciation to inflation. In the last 10 years, the rate of inflation was about 19 percent. So, the house you bought 10 years ago for $100,000 would now cost $119,000 to buy. Your real estate investment has not only kept up with inflation, but far surpassed it with added value and growing appreciation.

2- Increasing Income From Rents

Another huge benefit to owning real estate long-term is the potential for ongoing cash flow from tenants. A smart buy-and-hold strategy will cover your monthly expenses and generate cash flow. Property owners may also make small, annual rent increases, to help keep up with inflation and cover the cost of rising expenses. As rents increase, your rental property should produce enough money for expenses, plus cash flow that goes into your pocket year after year.

Real estate has become a popular investment strategy. Many long-term investors use this passive income to pay for their kids college, save for retirement, build real wealth, or to buy additional rental properties.

3- Depreciating Debt

Why not make debt work for you instead of against you? If you own real estate, that’s exactly what you’re doing. Real estate is an asset that appreciates in value. While the money owed on your property is actually depreciating, thanks to inflation.

Because inflation decreases the value of money, your monthly mortgage payment will be the same now (assuming a fixed-rate loan) as it is in 10, 20 and even 30 years.

Inflation and Real Estate Prices

There is a relationship between inflation and real estate prices. That’s because inflation impacts any sort of good with a restricted supply. Increasing the money supply causes both inflation and home prices to rise.

Interest rates are another big factor that leads to an increase or decrease in real estate prices. Higher interest rates make it more expensive to borrow money to buy a home. This results in lower home prices due to a drop in demand and a surge in supply.

On the other hand, when interest rates are low, people can borrow money relatively cheaply, causing the housing market to flip as an influx of buyers enter the market. Home prices go up as demand rises and supply lags. This scenario would be considered a sellers market versus a buyers market because home prices are higher with fewer options on the market.

Investor Tip: To learn more about buyers vs sellers markets and how to time the real estate market, check out a recent article on our sister site here.

Pros and Cons of Investing for Inflation

Just as with any type of investing, there are pros and cons to each. The same holds true when investing for inflation.

Pros

Preserve portfolio worth. Investing during inflation should protect your portfolio’s buying power.
Diversify holdings. Spreading risk across multiple investments and assets is key to building and maintaining a strong portfolio. This applies to all investment strategies.
Maintain income’s buying power. Investing for inflation rather than stock-piling money away in your savings, will help maintain your purchasing power rather than eat away at it.

Cons

Increase exposure to risk. Don’t invest just to fight inflation. Relying solely on investing for inflation may result in exposure to more risk.
Divert from long-term goals. Changing your investment goals or timeframe in order to avoid inflation isn’t a smart strategy. Individuals need to evaluate their current financial situation and set goals according to future needs.
Overweight portfolio in some classes. If your portfolio is heavy with only one or two inflation-fighting assets, you’ll be exposing yourself to more risk.

Conclusion

Now that we know what inflation is and what causes it, we can be better equipped to handle its impact on the economy. Inflation rates impact every single consumer and business–for better or worse. That’s why one of the best ways to knock out inflation is through investing in real estate properties long-term. By doing so, investors will own a tangible, appreciating asset while inflation simultaneously eats away at mortgage debt.

Interested in learning more about real estate? Become a member of RealWealth (it’s free!) and start learning about the best real estate markets in the country and why our members are confident investing in these growing markets.

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