Investing Fundamentals

Inflation vs Deflation and Why It Matters

inflation vs deflation

What is inflation, what is deflation and what benefits to knowing? We’ll explain the basics and what you need to know to make sure your money keeps pace.

Inflation and deflation are terms you hear thrown around a lot but what do they mean and what impact do they have on us?

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What is Inflation?

The value of a dollar is determined by its purchasing power, the amount of things or services which that money can buy. When inflation increases, the purchasing power or our dollar decreases.

In the US, our rate of inflation is 3% a year on average. That means the newspaper that costs $1 now will cost $1.03 the following year. Inflation means your dollar doesn’t go as far as it once did.

Types of Inflation

Demand-Pull Inflation: This is caused when there is an increased demand for something which drives up the price. When demand grows faster than supply, the price goes up.

Cost-Push Inflation:If the cost to produce a good increases, a company increases the price to maintain their profit margin.

Monetary Inflation: This happens when there is too much money in an economy. Too much of anything makes the value or price go down.

The Impact of Inflation

Inflation is not always a bad thing across the board. There are winners and losers when inflation happens.

If you owe money to a creditor, you win! The cost of your debt is reduced. You really make out if the rate of inflation is higher than the interest rate on your debt. Inflation hurts your savings. A dollar saved now is worth less in the future when you need to spend it.

If your raise at work is not more than 3%, it’s not really a raise because it doesn’t preserve the buying power of your dollars. If you are someone who lives on a fixed income that is not adjusted for inflation, your dollar is worth less too.

If inflation in one country is higher than that of trading partner countries, the goods of that country are more expensive than imported goods. That can impact domestic producers and in turn, their employees

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How Inflation is Measured

Inflation is measured by a market basket. It’s an imaginary basket of goods whose prices are totaled up. The number is called a price index and the cost of the basket is compared over time. This number is the price index, the cost of the basket today as a percentage of the cost of the same basket in the starting year.

There are two price indexes used to measure inflation, consumer price index and producer price index. Consumer price index measures the change in price for consumer goods and services from the consumer’s perspective. Producer price index measures the average change of selling prices over time for companies that make goods and services, so changes in price from the seller’s perspective.

Controlling Inflation

The Federal Reserve is tasked with controlling inflation. Uncontrolled inflation can cause a recession. If the growth rate of the GDP exceeds 2-3%, demand can drive up prices leading to demand-pull inflation. The Fed slows growth by tightening the money supply, they allow less credit into the market. This makes it more expensive to borrow money which slows growth and demand and brings prices back down.

What You Need to Know

Year after year, inflation eats into the power of your dollar. You can buy less with that dollar. You have to protect your dollars by investing your money where it earns more than the average rate of inflation, 3%. The average return of the stock market over time is 7% so you’re beating inflation. The average interest rate on a savings or checking account is less than 1%, less than inflation so you are losing money when you have it parked in one of those low yield accounts.

When inflation is high, interest rates go up so if you want to buy a house or a car or borrow money to start a business, you’ll pay more in interest. The biggest impact of inflation though is on your retirement savings.

To use round numbers, if you estimate you will need $1 million to retire but you aren’t retiring for 30 years, you will need almost $2.5 million to buy the same amount in 2047 that your million dollars in 2017 would buy if inflation remains at 3%.

What is Deflation?

Deflation is the opposite on inflation, prices of goods are falling. Deflation happens much less often than inflation and when it does happen, it typically doesn’t last long. Deflation is usually seen during a recession.

Causes of Deflation

There are two main causes of deflation, a fall in demand, people are buying less and because the cost to produce goods decreases due to improvements in technology.

The Impact of Deflation

Deflation is good right? Prices are dropping so people will buy more and people buying things is what drives the economy. A deflation rate of 2-3% is good and where the government tries to keep it. But continued deflation is not good for the economy.

If prices keep getting lower, people keep waiting to spend money, waiting for things to become even cheaper. So people stop spending. If people aren’t buying things for long enough, it hurts businesses, if it hurts enough, businesses start laying off workers. When people are unemployed, they spend even less. Down, down, down until it’s a full blown depression.

How Deflation is Measured

Deflation is measured using the same price indexes used to measure inflation. Inflation is an increase in those prices, deflation is a drop in those prices.

Controlling Deflation

Just like inflation, the government wants deflation to hover around 2-3%. The Fed can increase the money supply through the sale of treasury securities. If the supply of money increases, it becomes less expensive. Every dollar can buy more, driving prices up.

The Fed can ask banks to increase the amount of credit available. The interest rate is lowered so people borrow and spend more. The Fed can also lower the reserve rate, the amount of money commercial banks must keep on hand. This decrease encourages the banks to loan more money.

What You Need To Know

Deflation makes buying things cheaper so in the short term, it’s a benefit for us. Our salaries are the same but prices are dropping. But over the long term, the economic spiral can happen and result in unemployment.

Protect Yourself

Deflation is pretty rare and doesn’t last long when it happens. Because it can have such devastating consequences on the entire economy, the government acts quickly to control it. It’s inflation that we have to be more concerned about. Day to day we don’t feel much impact but we have to make sure we insulate our retirement savings from being eaten away by inflation.

Investing in the stock market will, overtime, protect your money from inflation. The average market return is 7% against 3% inflation. There are annuities offer guaranteed income for life with increases over time. And our favorite, invest in real estate. Whether that means owning rental property or investing through a company like FundRise, real estate, over time, is a safe way to hedge against inflation.

Notes

Allagash Tripel: A golden ale with a long, smooooth finish.

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