Running With Scissors

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It's become something of a game in the US these days to try to decode the often-cryptic words of Alan Greenspan, Chairman of the Federal Reserve, the central bank of the United States. People in the financial services industry and even average investors look for Greenspan's latest pronouncements, hoping to get a hint about our economic future. One of the words they listen for is 'inflation'.

The Fine Print

The articles in this series do not offer specific financial advice. Instead they will present financial tips, with occasional smart-aleck observations and commentary, that may or may not be useful in the reader's particular situation. You should always seek advice from a professional who is familiar with your personal circumstances before acting on any of the information presented in this series.

What Is Inflation?

The term 'inflation' refers to a trend of generally rising prices for goods and services over a period of time. Countries use indexes that calculate the cost of specific goods and services to measure inflation within their borders. As prices rise, the value of individual units of currency such as pounds, euros or dollars falls. In other words, a person will be able to buy less and less with that pound as time goes on. The rate of inflation can vary widely, from modest and controllable levels of a couple per cent to out-of-control levels in the triple digits (think back to your history lessons about housewives pushing wheelbarrows full of money to the market to buy bread).

Inflation has an 'evil twin' of sorts known as 'deflation', which is a period of falling prices. This may sound like a good thing if you’re a consumer, but as we’ll see below, both inflation and deflation can have unpleasant consequences.

What Causes It?

Prices of goods and services are affected by supply and demand. In general, if there is enough of an item to meet the demand, then prices remain more or less stable. If, on the other hand, the demand for an item exceeds the supply, then prices will rise because sellers can in effect sell to the highest bidders. The price of goods can also rise if wages of those who produce the goods outpace their productivity. Lastly, governments can cause inflation when they run large deficits and print more money to accommodate their overspending.

To understand the effect of rising prices, let’s look at an example many of us will be familiar with, namely oil. In recent years the price of a barrel of oil has been rising due largely to increasing world-wide demand.

Now consider what happens as fuel prices rise. For one thing, it will cost businesses more to make and transport their products. Higher oil prices will encourage businesses to look for other sources of energy (such as natural gas), which will lead to higher prices for those other sources as well. Thus producers have to pay more to heat and power their facilities. Raw materials may also cost more because of increased shipping costs. At some point the businesses will have to raise the prices of the items they produce in order to remain profitable. This in turn will make their products less attractive to consumers. Meanwhile consumers are also paying more to heat their homes and drive their cars; at the same time food has become more expensive because farmers and food processors must pay more to bring their items to market. Consumers will have less money for non-essential purchases, which further discourages consumption. Thus the rising price of oil ripples through the economy, as the cost of many other items rises in turn.

Not only are we affected by rising prices within our own borders, we will also notice the effects of inflation in other countries. For example, if prices are rising in our own country, then businesses that export our products to other countries will be hurt, as these products become relatively more expensive and less attractive to foreign customers. Conversely rising prices in other countries will make their products more expensive for us (and our country's products relatively more attractive).

Why Should I Care?

A modest amount of inflation generally isn't noticed too much by consumers as long as their wages keep pace and prices don't jump dramatically. However, over the long term inflation can do a lot of damage. Persons who are living on fixed incomes will see their standard of living erode. In fact, if your income remains the same for an extended period of time, even a modest amount of inflation will have a significant impact:

Inflation Rate (annual %)Prices Will Double In (years)

Nowadays it's not unusual for persons who retire at the age of 65 to live another 25 or more years. An annual inflation rate of 3% would mean that those retirees who are living on fixed incomes could see their purchasing power cut in half during these years. Worse, at the same time they will typically see their medical expenses rise dramatically, so ending their lives in poverty is a not unrealistic prospect.

Businesses and governments can find it difficult to plan for the future during periods of inflation. As prices rise, people tend to reduce their spending, which in turn reduces corporate profits, and in fact may cause fledgling or struggling business to fail altogether. Business owners will try to find ways to reduce their expenses in order to preserve their profits, including reducing the number of employees. Even if you’re not living on a fixed income, you don’t own your own business and you aren’t made redundant, you’ll be affected by inflation, as it can lead to a declining standard of living and decreased revenues for local and federal governments, which in turn can result in lower levels of social services.

Investors pay attention to inflation rates because a country will raise interest rates to combat it. Rising interest rates are bad for stock owners, because businesses have to pay more to borrow money, which in turn lowers profits (and consequently the value of shares of stock). Higher interest rates also lower the value of any bonds investors may own. The only investment that benefits from rising interest rates is cash (ie, money market accounts and the like), as interest rates on cash will also riseThe interest rate in such investments is always lower than the rate of inflation, though, making cash the least of several evils.

So you can see that inflation — even modest amounts — isn't benign. By contrast, you’d think that a period of deflation with its generally lower prices would be good for everyone, as it would encourage consumption, and as with inflation a very modest level doesn’t do too much damage. But if the rate of deflation picks up, consumption actually declines. Why buy that sofa today, people reason, if I can wait six months and buy it for less money? This in turn hurts businesses. They don’t want to lower prices even further, and they certainly can’t raise them. Cutting production reduces sales even more, and increasing production makes no sense because they’re not selling what they already have on hand. They’re stuck, so they have to resort to reducing expenses (ie, making workers redundant) until people start buying their products again. So while inflation is bad and concerns everyone, the prospect of deflation really gives businessmen the heebie-jeebies. And when business is hurting, everybody is hurting.

What Next?

Right now the developed nations are feeling the effects of two competing forces. On one hand, increased globalisation is putting downward pressure on prices, as businesses move their production facilities to developing nations with much lower labour costs. On the other hand, as these developing nations modernise, their demand for oil rises and this in turn pushes prices upward. OPEC nations are also concerned about oil prices; higher prices mean increased profits for them, but at some point higher prices will lower the demand for oil as other countries cut usage and look to alternative sources of energy. In fact, there is some evidence that higher gasoline prices in the US are finally accomplishing what environmentalists and politicians have so far been unable to do.

Forewarned is forearmed. While we can't as individuals do much to control rising prices, we can understand their impact and plan accordingly. It's particularly important for those who are hoping to retire one day to understand how inflation can erode the purchasing power of our pensions and to adjust our saving and spending habits so that we don't end up old and broke. And understanding the basics of monetary policy helps us evaluate which of our politicians has a clue, so that we can vote for those most likely to keep our financial ship afloat.

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