What Are the Top Three Things People get Wrong About Inflation?

Misconception #1. The Cause of Inflation

The root 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 supply of money being $1000. If the issuer then doubles the supply to $2000 then you can buy half as many things with your $100.

We see three primary 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-pull inflation
• Cost-push inflation
• Built-in inflation

Demand-pull inflation

Demand-pull 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 more resources are chasing the same supply.

A good example is the state of the travel industry post covid lockdowns. Travel demand skyrocketed without the industry having the opportunity to build up its supply. As a result, there was more demand than supply, so travel agencies increased their prices to reduce demand.

Cost-push inflation

Cost-push inflation is often correlated to demand-pull. It occurs when the raw material costs increase for businesses, and the businesses raise their prices regardless of demand.

A good example is when the price of produce rises; restaurants will raise their menu prices to adjust, regardless of if they have more customers.

Built-in inflation

Built-in inflation is usually a response to the previous two. Employees may ask for a raise to help cover the increased costs from demand-pull and cost-push inflation.

Employers are then faced with the choice to increase wages to remain competitive or face a labour shortage. Employers will then pass on the increases to customers by increasing their prices. 

Misconception #2. Inflation is Pointless

Currently, the United States Dollar is the world’s strongest currency and is used as the world’s reserve to denominate every other currency. The U.S. dollar we know today was created under the Federal Reserve Act of 1913. At this point, the U.S. dollar was operating under a gold standard whereby the value of the dollar was linked to the value of gold reserves the U.S. held.

It was not until after WWII that other nations would agree to the U.S. 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 maintained the central banks’ authority to maintain an exchange rate with the dollar. In return, the U.S. would allow countries to redeem the dollars held for gold. Since 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 to gold from foreign nations, effectively ending the Bretton Woods Agreement.

The dollar remained the global reserve currency, but a hard asset no longer backed it.

This allowed the U.S. government to directly control the supply of money issued. The U.S. started increasing the money supply to pay for new projects, which inevitably led to The Great Inflation. Effectively, this marked the beginning of Modern Monetary Theory.

The U.S. central bank targets 2-3% annual inflation to encourage people to spend now rather than save for later. However, when the U.S. issues too much currency over a short period, we see a sharp increase in inflation, like we witnessed in 2022.

Misconception #3. Inflation is Predictable

There are a couple of solutions to help solve or at least weather periods of heightened inflation. The first way is to find assets that will preserve wealth over the long term.

Traditionally, this has been achieved through gold, stocks, and real estate. As inflation increases, so does the value of these assets.

This is an excellent option if you can do so financially. However, this is only an option for some people and will ultimately lead to greater levels of inequality. The rich get richer, while the lower and middle 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 monetary supply. This is done through the raising of central bank interest rates.

Increasing central bank interest rates will directly lead to less borrowing.

Businesses may decide not to invest further into their business if there is a high cost to taking a loan out. Similarly, people with variable rates on mortgages and loans may be forced into selling their assets if these interest rates increase too much.

This method can potentially lead to a recession if the rates rise too quickly or too steeply. It also can lead to periods of austerity as governments are forced to spend less.

Concluding Thoughts: Inflating the Future

Bitcoin may provide an alternative. Not as a hedge against inflation but as a way to remove it. Bitcoin has an absolute scarcity built into it of 21 million bitcoin. This effectively means it is the hardest money on the planet.

A return to a gold-like standard as an alternative for governments. One where they can only spend what is backed or borrowed against it with the risk of losing it. This would effectively cut out the threat of the money printer producing higher inflation.