MT12 | The One Thing Affecting Your Entire Financial Future (Inflation Causes And Effects)

I’m sure you’ve heard your parents grumble about how everything is so expensive nowadays. Back when they were kids, it seems like food cost nothing, fuel cost nothing, and even their homes cost pretty much nothing. Yet today we seem to be struggling to pay for even the basics of life.

But why is it that a few dollars could buy a month of groceries 50 years ago, but now it isn’t enough to cover a single family dinner out?

In one word – inflation. Inflation is the single most important thing affecting your income, savings, investment and wealth creation – in other words pretty much your entire financial future, so whether you are a salary/ wage earner, a new or experienced investor, or even a home-maker responsible for the household budget, this is something you absolutely must know about.

Discussion Topics: The One Thing Affecting Your Entire Financial Future (Inflation Causes and Effects)

• What is inflation and why do prices rise in the first place?
• How increasing demand for goods and services impacts inflation
• The role individuals play in inflation, sometimes overcoming even central bank efforts
• Hyper-inflation and stagflation – some really bad things
• What professional money managers consider ‘good’ inflation
• The impact of money-printing and excessive stimulus is increasing the risk of ‘bad’ inflation and inequality
• Governments might be flying blind, unable to see the real effects of their actions
• Therefore, more than ever, we have to take charge of our portfolios and invest to beat higher inflation

Transcript: The One Thing Affecting Your Entire Financial Future (Inflation Causes and Effects)

I’m sure you’ve heard your parents grumble about how everything is so expensive nowadays. Back when they were kids, it seems like food cost nothing, fuel cost nothing, and even their homes cost pretty much nothing. Nothing like today, right, when we seem to be struggling to pay for even the basics of life? But why is it that a few dollars could buy a month of groceries 50 years ago, but now it isn’t enough to cover a single family dinner out? The answer is inflation. Inflation is the single most important thing affecting your income, savings, investment, and wealth creation – in other words pretty much your entire financial future, so whether you are a salary/ wage earner, a new or experienced investor, or even a home-maker responsible for the household budget, this is something you absolutely must know about. Let’s get into it!

Hi, everyone, welcome to another episode of MoneyTok, where we help make personal finance and investing simple and accessible through both my own experience. I’ve been doing this for about 20 years now. This show is about money and wealth creation. And we talk about so many ways of making money, bought retirement planning about stocks, bonds, gold, real estate, crypto, and so many kinds of things.

And once again joining me is Neha Agrawal, an experienced professional trader and a co-traveller on the journey to wealth and financial freedom.

Before we start, a quick reminder that most of our episodes come with free tools, templates, or other resources you can use on your own financial journey. These are linked in the episode description, so once you’re done listening, feel free to log in, make a copy, and start using it for yourself

Today we have a simple, yet powerful decision tree that Neha prepared for anyone to be able to sense-check or design their investing strategy in accordance with the drivers of inflation in their own country. Take a look – it will really transform how you think about your overall portfolio.

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What’s inflation?

Inflation is one of the most fundamental concepts in economic construction and one of the key deliverables for any well-functioning economy.

Oh wait hold on. You said inflation is deliverable. You meant key outcome, right?

No, I did mean deliverable. Inflation as such defines the rise in price of any goods or services or assets and so Central banks and governments actually target a specific level of inflation they want to achieve using the various tools at their command. It is traditionally assumed to have a reasonable positive value, i.e. a rate of 1-2% rise in prices year on year and they usually track it by monitoring the change in prices of a representative basket of goods mom and yoy. Depending on the basket of your consumption, inflation could impact you differently from another household. Not all prices for everything move in sync, nor do all economies face similar price rises. If you live in a naturally recourse-rich but labor resource-poor economy, goods prices don’t rise as much but prices for services like plumbing keep rising.

OK but why do prices rise in the first place? Why don’t they just stay the same all the time? Isn’t it easier for everyone that way?

Well to put it simply, if demand for something increases, while supply cannot keep pace with the rise in demand, the prices will rise. There has been a very simple factor for rising prices in the last century, and that is demographics. As consumption has gone up, populations have matured, and more people have risen out of poverty, the demand for resources, goods, and services has risen, while supply has been constrained by the finite amount of land or oil, or commodities. So as the country develops more, i.e. increases income and consumption, there will be some amount of inflation. It is generally considered a healthy sign of growth. There is usually some lead-lag effect in demand and supply. Rising demand will be responded to by rising supply.

If by some chance, you achieved total balance in the economy, i.e. everyone consumes exactly as much as they can produce, and there is no change in consumption pattern and demand, you will have no price rise and no inflation. But what is that a sign of? No change or increase in demand means there is no growth. Your paycheck will remain constant year after year, and you will eat and consume the same things year after year. Which is good, but also very Boring right? Hence moderate ‘demand-driven’ inflation is considered a healthy sign and important for the propagation of growth.

Now if we take the basic equation of rate of change of demand or (D)-the rate of change of supply(S) = rate of change of prices aka inflation or (I), we can try to tweak various variables in this equation and see how it changes the impact on the economy. If D is slightly higher than S, you have a healthy I. It pushes savers to deploy capital in productive investments and it gives the producers incentive to put capital to use, creating employment opportunities, leading to growth

OK, so this is the good inflation you were talking about. But say during covid I’m sure people who lost jobs didn’t have money so they might not have been buying things at the rate they used to earlier.

Yes so if D is lower than S, which means demand is tapering off, you get deflation. That is not a good sign. It will prevent industries from expanding, therefore no growth in employment opportunities, no allocation of capital and hence no economic expansion. An example would be Japan.

Wow, that sounds terrible. I guess then governments should just massively boost demand like they are trying to do nowadays with stimulus checks. Why not just give everyone a million dollars, then we’d have great demand and growth and all the good stuff. Plus I’m sure all that industrial growth will make small economies into big ones overnight.

Not at all. If D is higher than S by a huge amount, either because supply has cratered due to supply shocks, or because of some spike in demand due to disturbance (say war or natural disaster or what you just suggested), it can lead to hyperinflation. That is economic doom. And finally, you can have a scenario where you have inflation without accompanying growth. That is called stagflation. This again, obviously is not ideal. Let’s discuss these more in depth.

Inflation due to demographics

As we already mentioned, mild inflation is a sign of growth, and in fact propagates growth. As long as it is coming from an increase in demand and not a decrease in supply. Demand could be increasing because of demographics, which means a higher proportion of younger people who consume more than older demographics. It could also mean more people are being able to consume as their economic status improves and disposable income goes up.

This is the reason why typically a developing economy which has both a young population and income growth advantage like India has a higher inflation, while an already developed country where incomes have stabilised and population has aged, like Germany, will have a lower inflation rate. When suppliers have an expanding market to produce for, they will have a better deployment of capital, put a stress on innovation, employ more people and thus you get growth. Thats why China and India have been such big focus markets for all big companies as their favourable demographics provide a ready market for the produce. So countries with a younger population actually could generate the right kind of inflation for sustained growth.

So in other words, having babies is a patriotic duty. You heard it here first folks. Get busy!

Inflation due to income-boosting productivity

You could also get inflation because of healthy growth. Typically technological developments lead to huge growth spurts and resultant shift in consumption pattern, as the economy climbs the rungs in the development ladder. Industrial revolution, green revolution, and the IT revolution have all boosted productivity, while generating increased per capita income, and hence have seen resultant acceleration in demand.

Inflation due to consumption

By the way, demand could also increase in the absence of favourable demographics or positive changes in productivity, and that is when the same people have more money to spend. Simply because they have been given more money in their hands. This is kind of what you were talking about with the $1M checks and what has been happening in a lot of developed countries like Japan and US. US has seen levelling population, and a plateauing in consumption (it in fact accounts for one of the world’s lowest savings rate, because people have traditionally spent most of their money, so there’s not much more room to spend).

So, if you think of the economy as a restaurant with a large kitchen, it needs people to buy more and more food. So how could it push people to eat more even when their tummies are full? One way is by increasing the buffet spread. So the economy could just make a wider variety of things and create more choices for consumers to spend on.

Inflation due to stimulus

Alternately, it could give you vouchers to spend on the buffet. In economy terms, this is the same as printing money, and distributing it through fiscal and monetary policy. An example of fiscal policy is increasing minimum wages, or tax cuts, and example of monetary policy is lowering interest rates, making it cheaper to borrow money.

Nice one Neha. I love the restaurant example. Think I’ll steal it in case anyone asks me later.

So in the first case of improving demographics, or increasing innovation, you intrinsically have inflation built in, while in the second case, you are trying to create inflation via money printing and fiscal policy. And because both scenarios ideally lead to increased production, and its resultant multiplier effect in the economy, central banks want to keep some inflation going.

US central bank’s policy, or even Japan’s for that matter has been to achieve and maintain a 2% level of inflation, and they will tweak their policies to try and achieve it. While developing countries like India, Indonesia and China have been trying to keep the lid on inflation, tweaking their policy to somehow maintain it in a 4-6% band and not let it go too high.

Hey Neha, all this is fine but what’s the role of people in all of this. All this discussion makes it seem like we are puppets in some grand master plan. The central bank just sets some policy and pulls strings and then we just dance to their tune. Isn’t there a place for our own desires and expectations? After all we are the ones actually spending the money

Inflation expectations and self-fulfilling prophesies

Yes actually we do play a big role in all this. A very important point I would like to mention here is inflation expectation. In the equation I mentioned earlier, D-S = I, we also need to add a component of I(e) which is the expectation of inflation.

Inflation is sort of a self fulfilling phenomenon. If the population believes there will be no inflation, there is no incentive for consumers to consume today. Believing that the value of money will remain the same today and tomorrow, so they can easily push consumption out in time. Also, they will be satisfied with investing less. You might as well keep cash under the mattress since its value will not change. So more savings, less consumption, less investment, less production, less employment generation and so on. And hence you actually have an economic slowdown and a resultant stall in inflation.

On the other hand, if one expects inflation to rise, they will increase present consumption, chase after assets (you can refer to our earlier podcast on financial asset inflation), thus causing demand to outstrip supply even further and therefore increase inflation even more. So it can work as a virtuous or vicious cycle.

As an example, Japan, despite everything the central bank has tried to do has remained stuck in deflation because people are now used to deflation and believe that prices will always go down. So they don’t spend. And that expectation continues to perpetuate deflation in the economy. So central banks always try their best to contain inflationary expectations in a narrow band through their policy. It is dangerous to let inflation move out of that band because it sets deflationary or high inflationary expectations which then kick off all the bad things we talked about.

Wait what does high inflation expectation result in? Should boost spending today right? And that’s good for growth? Or no?

Hyper-Inflation

Yes so that is actually all about hyper-inflation, which is definitely not a good thing. If, for some reason, you think tomorrow your money will be worthless, or because there is a disaster coming for which you need to store goods, or because you think supply is going to get disrupted, it leads to hoarding. (Didn’t we all witness toilet paper hoarding last year!, thank god it was only toilet paper)

Hoarding generates scarcity and a huge gap between D and S. Even if all the factories produce as much as they can their capacity is limited and so overall Supply can in no way match this shock to demand. And if not contained, it can spiral into hyperinflation. It makes the value of paper money totally worthless and results in looting, hoarding, and general destruction of the social structure.

Money is a glue, a story that binds the economic system, and if that glue comes unstuck, it is an economic collapse, leading to a humanitarian crisis. We have seen Venezuela and Zimbabwe go through hyperinflation in recent years. It has led to political instability and destruction of wealth, retarding the economic growth of decades. Venezuela recorded an eye watering inflation rate of 65300% in 2019, and Zimbabwe had clocked 535% last year. This is annualised rate. For brief periods of time, it even touched a million%, which basically meant the money in your hand was worth less than the paper it was printed on.

We have seen what a social, economic and humanitarian crisis that leads to. The medicine to recover from this is usually very painful, and like chemo for a cancer patient. Hence it is always a big worry on the horizon for emerging market economies.

Stagflation

And finally we have something called stagflation. We have discussed how mild inflation is not only a good sign of growth, but is also key to growth. But there can be times when we have inflation, which is not accompanied or followed by economic growth. This is called stagflation. Money printing led growth and inflation can often result in stagflation, because while inflation is being fuelled by the printing press, growth is anaemic since it is not backed by the fundamental drivers that we discussed, which are demographics and productivity. It’s like treating an illness with panadol. It masks the symptoms but doesn’t address the real diagnosis.

Stagflation can also occur when there are price shocks on the supply side. An example of that is US in 1970s, when oil prices surged. The producers pass this rise in cost to the consumers, and they in turn do not like the sticker shock, thereby decreasing consumption, causing economic recession. That brings us to the next variable, which is Supply

Supply-side inflation

So Neha, all this sounds like inflation management is a very tricky problem. Not only do governments have to calibrate demand and supply measures to ensure inflation remains a low positive number, they also have to manage perceptions so people don’t rush off en masse to do things that might kick off deflation or hyper-inflation cycles. And on top of that even for inflation within the band they have to ensure its driven by the right kind of things so it is beneficial and sustained. Since this is so tricky, I’m sure investors, especially professionals such as yourself have to figure out what’s good and what’s not so you can take positions accordingly. How do you do that?

Investors read inflation prints to glean the health of the economy. In some countries like Singapore, a rising inflation print is like a good report card, leading to a buoyed stock market. In other countries like South Africa and India, a higher inflation print will lead to a beating of the stock market due to investor wariness.

Why the difference? more often than not one is demand led and another is supply led inflation. If increasing demand due to improving economic standards is leading to inflation, that is good. If inflation is high because graft, red tape and general inefficiencies are creating infrastructural bottlenecks and investment is crippling the supply chain, then it is bad.

Why? Because inflation reducing actions are typically one-sided and act to reduce demand, like making the price of borrowing higher (i.e. raising interest rates) or devaluing the exchange rates to makes imports more expensive. So if the issue is with supply, these measures are only good for the short term because how long will you keep people from buying what they need? In the long run, supply related scarcity can only be sorted via proper investment planning, and requires efficient fiscal policy, which takes time to fructify.

The short term solutions (taken to ensure inflationary expectations do not start setting high) are usually a painful dose of medicine. High inflation (not hyper inflation) also makes long term capital investment dearer due to higher interest rates. Hence again a growth-strangling viscous cycle. And a way to distinguish between the two is to see if inflation is also being accompanied by wage growth, or increasing employment growth.

Inflation from excess money supply

Now we’ve already discussed how deflation and hyperinflation are really bad. But what is also bad is inflation from pure money printing. Macro economics 101, you print money leading to excess supply of money, leading to loss in money’s value aka inflation.

Since Central banks, act like a dampener, they always need to lean opposite to the prevailing trend of the time in order to control economic growth and inflation. If demand is heating up, meaning economic engines are chugging, they reduce money supply, or raise rates. This leads to cooling in demand, and growth. And when economy is shrinking, or demand is petering out, they will make borrowing cheaper, and/or print more money.

And this is what has been happening for the last 13 years. There has been a desperate attempt to reflate developed economies through almost an indiscriminate printing of money. Ideally it should lead to inflation. But for a long time it hasn’t. A combination of aging population with low demand plus an internet economy producing supply chain efficiencies and subsidising goods has kept a lid on prices.

Correction: it has kept a lid on prices of goods. Consumer has been the king, as Amazons and Ubers of the world have poured angel money and smart phone technology to win expensive price wars. But prices of services (like education, leisure, travel) have gone up, and so have those of assets. This is not good.

Why? because there has been no increase in wages. That means production is not going up, employment is not going up. You have the same pay check as you did a decade back, and the only way to grow your wealth has been through financial investment. Housing market has been priced out for most. And inequality has increased. Those who had investible surplus to begin with, have been able to increase their wealth, and inflate the demand for leisure and education. Those who got left behind, have seen no increase in their bank balance.

But why is that? After all the government should have been tracking inflation and hence adjusting things like minimum wages right?

Issues with headline inflation figures

The headline inflation used for policy setting and checking the pulse of the economy can be misleading at times. It is subject to a lot of modification depending on what basket of goods you choose. Greece, infamously tweaked its basket to arrive at a headline inflation of 3%, a requirement for getting entry into the Eurozone, when the actual household inflation was far above it.

Similarly, based on your own consumption basket, your experienced inflation can vary from the headline number. In the recent years, the basic basket has not risen in prices, and falling oil prices have also helped keep inflation low. But for the middle class, looking to buy a house, or a young graduate looking to repay his student loan and start his investment nest, things look very different.

The headline number itself throws a blanket on the increasing inequality, the asset price inflation, and allows the central banks to continue to pump money without consequence. But it seems the day of reckoning may be coming sooner than we think.

Retirement planning to target inflation

So given that the government is possibly operating with incomplete information it looks like we have to just trust in ourselves to establish a secure financial future. So how should we future proof yourself with an investment strategy in this scenario?

You have to focus on achieving a real rate of return on your assets, and not nominal. Real rate is nothing but the rate of return minus the rate of inflation. If you get 5% on your fixed deposit, but have a 5% erosion in value of money (i.e. inflation), you are breakeven.

First you have to understand what kind of economy you are in. In an emerging market economy, inflation is a constant worry, and so interest rates are typically higher. These are economies with favourable demographics, and a higher demand for real estate with increased urbanisation. So investment in real estate and growth stocks would be ways to stay ahead of the curve. Government bonds, or FDs may not be able to beat inflation as much. Bear in mind, I am talking from a long term perspective, and not a short term investment strategy. In more mature economies, there is hunt for technological revolution. so look for maybe stocks which have been dipping into new technologies like say renewable energy.

But also keep in mind if inflation rate is outside the band prescribed by central bank, it will lead to a hike in interest rates, which usually leads to correction in stock markets. Also keep a track on wage inflation. It is something central banks look at closely too. Ideally wages should be growing as a sign of higher demand for labour, with increasing production. This will allow you to get a sense of bad inflation vs good inflation.

Also a very fluctuating inflation number is bad for investment projection, as ROI calculation becomes difficult. So ideally you want a gentle steady inflation. If you are in an open economy where you can invest outside your borders, look for investment routes in other growth economies. They also will typically have higher yields on their bonds. Which is why Mexican or Indonesian bonds are very popular with Japanese investors since Japanese bonds yield 0.

But you have to keep in mind the exchange rate factor here, which is the subject of another podcast. Keep a track of your consumption basket and track your expenses month on month. Your experienced rate of inflation maybe quite different from the average rate. But at the same time, that economic number and central bank guidance gives you a sense of interest rate trajectory.

Last decade has seen a rise in almost all asset prices due to money printing. Inflation has remained subdued. But the last few inflation prints have been some of the highest in recent decades. When the reckoning comes, we should see almost all asset prices come down in unison. But a blue chip company, an FMCG, or utilities, will remain a staple irrespective, and will correct less. Cities will continue to see increased population growth so real estate is also a good long term bet. But as inflation numbers start creeping up, be ready to stand by with investible cash. When the printing press stops, and resultant correction happens, make sure you have money to invest rather than be licking your wounds.

Summary

Inflation is change in demand – change in supply + inflation expectations. demand led inflation, which stokes capital investment, employment generation, and resultant wealth creation is good. But supply inefficiency related inflation is more painful and long drawn to weed out.

Then we have deflation, where prices are falling year on year, and there is a resultant economic stagnation or recession.

We have stagflation which comes with sudden supply shocks leading to fast rise in prices which instead of fueling economic growth actually stagnates the economy

And finally you have hyperinflation which is a runaway inflation and usually leads to socio political crisis.

And the kind of economic model you live in, and the phase of economic cycle you are in, will dictate how you should try and achieve a rate of return higher than the inflation rate you are living with. And that’s where the simple decision tree linked in the notes will really help. So do check it out