While inflation has always been part of our economy, 2022 offered a crash course for many people who had previously ignored its impact. That’s because 2022 saw historic levels of inflation in most economies.
Depending on where you are in the world, you could easily have seen your central banks’ annual target triple by 2-3%. This annual inflation of 6-7% was one of the least damaging cases.
Many other countries, including the UK, have seen acute double-digit inflation, while others have fallen into hyperinflation and the devaluation of their national currencies.
The impact of inflation has left many people looking for answers about where it came from, how it went so badly and how we fix it. Here are the three things most people get wrong about inflation.
Misconception #1. The cause of inflation
The main cause of inflation is the introduction of additional currency into circulation. If a central bank increases the money supply by issuing new currency, then the current supply will be devalued. Say, if you have $100 with the total money supply of $1000. If the issuer doubles the bid to $2000, you can buy half of the stuff with your $100.
We see three main types of inflation that are often mistaken for the cause rather than the effect of the increase in the money supply. They are all ultimately a reflection of the increase in the money supply. The types of inflation we recognize are:
- Demand-driven inflation
- Cost-driven inflation
- Built-in inflation
Demand-driven inflation is what most people think of when they think of inflation. It is when there is an increase in demand for goods and services. This drives up the price as multiple resources are chasing the same offer.
A good example is the state of the travel industry after covid lockdowns. The demand for travel has skyrocketed without the industry having had the opportunity to build its offer. As a result, there was more demand than supply, so travel agencies increased their prices to reduce demand.
Cost-driven inflation is often correlated with the attraction of demand. It occurs when raw material costs rise for businesses and companies raise their prices regardless of demand.
A good example is when the price of products rises; Restaurants will increase the prices of their menus to adjust, regardless of whether they have more customers.
Embedded inflation is usually a response to the previous two. Employees can ask for an increase to help cover rising costs from demand-driven inflation and cost-driven inflation.
Employers are therefore faced with the choice of raising wages to remain competitive or face a labor shortage. Employers will then pass on the increases to customers by increasing their prices.
Misconception #2. Inflation is useless
Currently, the United States dollar is the strongest currency in the world and is used as a world reserve to denominate every other currency. The US dollar we know today was created under the Federal Reserve Act of 1913. At this point, the U.S. dollar operated under a gold standard in which the value of the dollar was tied to the value of gold reserves held by the United States.
It was only after World War II that other nations accepted the US dollar as a global standard. This would happen in 1944 during the Bretton Woods Agreement, when 44 countries agreed to peg their currencies to the USD rather than gold.
The agreement retained the authority of central banks to maintain an exchange rate with the dollar. In return, the United States would allow countries to redeem dollars held in gold. Since the USD was backed by gold, world currencies were indirectly pegged to the value of gold at $35/ounce.
In 1971, President Nixon ended the convertibility of dollars into gold from foreign nations, ending the Bretton Woods agreement.
The dollar remained the global reserve currency, but a strong asset no longer supported it.
This allowed the US government to directly control the money supply issued. The United States began to increase the money supply to pay for new projects, which inevitably led to Great Inflation. In fact, this marked the beginning of modern monetary theory.
The U.S. central bank aims for annual inflation of 2-3% to encourage people to spend now rather than save for later. However, when the US issues too much currency in a short period, we see a sharp rise in inflation, as we saw in 2022.
Misconception #3. Inflation is predictable
There are a couple of solutions to help solve or at least weather periods of rising inflation. The first way is to find assets that preserve long-term wealth.
Traditionally, this has been achieved through gold, stocks and real estate. As inflation rises, so does the value of these assets.
This is an excellent option if you can do it financially. However, this is only an option for some people and will eventually lead to higher levels of inequality. The rich get richer, while the middle and lower classes see their wealth eroded, trying to keep up with inflation.
It is possible to create a deflationary environment that decreases inflation by decreasing the money supply. This is done through raising central bank interest rates.
Rising central bank interest rates will lead directly to fewer lending.
Companies may decide not to invest further in their business if there is a high cost to take a loan. Similarly, people with variable rates on mortgages and loans may be forced to sell their assets if these interest rates rise too high.
This method can potentially lead to a recession if rates rise too quickly or too steeply. It can also lead to periods of austerity as governments are forced to spend less.
Bitcoin can provide an alternative. Not as a hedge against inflation, but as a way to remove it. Bitcoin has an absolute scarcity embedded in it of 21 million bitcoins. This effectively means that it is the hardest money on the planet.
A return to a gold standard as an alternative for governments. One in which they can only spend what is incurred or borrowed against it with the risk of losing it. This would effectively eliminate the threat of the money printer producing higher inflation.