Nuts and Bolts Part 1: Inflation - exactly what is it?

Reflation is coming. The Fed will have to move. Has the RBA created a ticking timebomb? Will inflation lead to a housing market catastrophe from higher rates?

These are just some of the headlines and market commentary that have been appearing in the post-COVID era to talk about inflation. They do paint a gloomy picture. We know the issue of inflation is becoming a concern for more of you, with the biggest questions about what inflation might mean for your borrowing costs, living standards and investments.  

So we thought we should do a three part series covering:

• What inflation is and why it matters.
• When inflation becomes destructive and how central banks in particular try to control it.
• And finally, how to beat it with investing.

Part 1: Inflation: Can you feel it?

Inflation is when the price of goods and services rises which in turn diminishes your purchasing power. To put it another way: your money today won’t be the same value tomorrow. Inflation is a concept that is hard to see but you can feel it over time.

For example, the average loaf of bread in Australia in 1990 cost $1.37. That same loaf of bread in 2020 is now $2.73 (source: ABS). If you had saved $10 in 1990 you could have bought seven loaves of bread and had some change. In 2020 that same $10 can only buy you three loaves and change - a loss of four loaves. Thus, your purchasing power has been eroded because of inflation.

Now, I understand this example is simplistic and there are other factors that play into inflation as a whole. But it does illustrate how inflation works overtime and why you can ‘feel’ inflation due to its impact on your living standards.

We need to point out that a steady and consistent rise in inflation is actually a good thing for all economies. Yes, it’s vexing to think your hard-earned capital is losing value over time. But a small amount of inflation actually encourages you to spend or invest your monies today rather than wait for some time in the future.

How does inflation occur?

So, we know inflation occurs, but what causes it to happen? To answer that question, we must turn to the economic principle of supply and demand.

(The Supply and Demand diagram)

Under the economic supply and demand theory, prices rises related to inflation are caused in two ways:

1. Demand-pull inflation
2. Cost-push inflation.

Demand-Pull Inflation

“Demand-pull inflation” is when demand for a good or service increases but supply remains unchanged therefore ‘pulling up’ the price. So, on the diagram above, demand would slide up its curve, meaning the price-to-quantity equilibrium point will have shifted higher up the price axis.

There are a few ways demand-pull inflation occurs. First, when the economy is performing well, people’s wealth and income also tends to grow. This leads to more disposable funds and a growing purchasing power that allows consumers to purchase more than before. This means increased competition on the existing supply of goods and thus leads to price increases.

A real-world example of this is Australian housing in the post-COVID era. Demand is extremely high yet the supply of housing in both the primary and secondary market is either flat or falling which is leading to record house prices (record low interest rates are also playing a part – we will discuss this in part 2).

Second, demand-pull inflation can be caused by a rapid increase in popularity of a particular product or service. The clearest real-world example currently is cryptocurrencies. The spontaneous surge in demand for bitcoin and the like where every crypto’s coin base has a cap (meaning supply can’t really change) is seeing mass demand-pull inflation in the price of these products, so much so that they can double, even triple, in value in 24 hours.

Cost-Push Inflation

Cost-push inflation is when the supply of a good and/or service falls but demand remains the unchanged, pushing up prices. Cost-push inflation is usually due to an event like a natural disaster (i.e. weather or a pandemic) that hinders a firm’s or provider’s ability to produce enough of the good or service to keep up with consumer demand. This leads to inflation.

We are living through a real-world example right now with COVID-19. Supply chains around the world have been significantly impacted by the pandemic leading to surging prices of raw materials, widgets and much more.

Another real-world example of cost-push inflation was the impact of Cyclone Larry in 2006 which wiped out up to 90 per cent of Australia’s banana crop. This led to mass inflation in banana prices as much as 500 per cent as demand for bananas at the store front remained unchanged.

In Part 2 we will look at when inflation can become destructive and how central banks using monetary policy try to control these destructive types of inflation.