In previous articles we traced the development of money from ancient barter systems to modern day fiat currency. One of the unavoidable realities of money throughout history is that as its supply increases, its value per unit decreases. This is the fundamental principle behind inflation which will be described in this article.
Inflation is defined as “a general increase in prices and fall in the purchasing value of money.” Put simply it means that given inflation, money that you have today will buy less in the future.
Inflation has existed for as long as money has existed and is not unique only to modern fiat currency. As was mentioned in a previous article, seigniorage is a practice wherein the authority that issues money profits by reducing the precious metal content of a coin (commodity money) but maintains the face value of the coin. For example, if you took all of the gold in a 100% gold coin, and made two 50% gold coins (blending it with another metal), you could produce two gold coins with 50% gold in them. This would increase the monetary supply, but once participants in the market realize that the gold content was now only 50% (despite being stated as 100%!), the value of the currency would decrease.
Inflation has also been documented as far back as with the progenitors of modern day paper money and fiat currency, the Song Dynasty of China. Inflation was so extreme at times in ancient China that by the time of the Ming Dynasty, paper money was no longer printed and coins were used instead for a period.
More recently, substantial inflation of the Zimbabwean dollar, more accurately termed “hyperinflation” was seen in Zimbabwe from the 1990s until 2009. Due to a faltering economy combined with excessive government printing of money to finance wars, the monthly inflation rate reached a peak of 79,600,000,000% in November 2008. With inflation this high, Zimbabwean dollars needed to be exchanged for another currency immediately after being received in order for them not to lose the majority of their value. A sample one hundred trillion dollar note is shown below, which was worth approximately $300 USD when initially issued in 2008.
There are many different economic theories as to why inflation occurs. Economists generally agree that in the long run, the growth rate of the money supply relative to the growth rate of the economy dictates the inflation rate.
In the short term, factors like supply and demand, interest rates, and pressures in the economy (ex: increased government spending, natural disasters, sudden increases in supply of resources, etc.) can affect inflation.
A commonly used measure of inflation is called the Consumer Price Index (CPI). The CPI is the relative change over time (often years or months) of a “basket” or group of products that the average household purchases to maintain a certain standard of living.
The CPI basket contains items such as: groceries, electricity, gasoline, clothing, and mortgage interest. The Statistics Canada website provides a full breakdown of the basket.
The CPI can be calculated simply as: (price2 – price1)/price1, where price 1 and 2 represent the prices of the CPI basket in two different time periods. The Canadian CPI (annual) from 1995 to 2014 is presented in the following figure:
In addition to the annual trends, the figure indicates that inflation in Canada over this period (measured by the CPI) averaged 1.92%.
There are many criticisms of using the CPI to measure inflation. Chief among the concerns is that the CPI is calculated assuming a constant standard of living, rather than solely looking at the costs of the underlying goods, or the commodities prices underlying the goods themselves. However, the government-produced CPI calculations are generally accepted as a reasonable approximation for inflation.
The first and foremost effect of inflation is to reduce the relative purchasing power of the underlying currency. This means that money you have today will be worth less tomorrow. However, there are additional effects that investors should be aware of:
- Increased taxes: Inflation (without adjusting tax brackets for it) can cause income earned to appear higher and thus be taxed in a higher tax bracket;
- Unpredictability: individuals are less likely to save money if they are uncertain of its future value;
- Fixed Incomes: those with fixed incomes, such as pensioners, or those receiving annuities not indexed to inflation will suffer as their fixed income purchases less and less;
- Bond prices: as inflation increases, the Central Bank may raise interest rates to control inflation. This typically has a ripple effect on the interest rates of all fixed income instruments (bonds). As a result, bond prices decrease, and owners of existing bonds could suffer a loss in value;
- Stock prices: stock prices typically have a conflicting relationship with inflation. Dividends often do not keep up with inflation; however, moderate inflation is often positive for the stock market as long as companies can pass increased costs on to their customers. Further complicating things, the discount rate used to value many companies (particularly growth companies) increases with inflation which can decrease the estimated value of the company.
The government’s Central Bank uses a variety of policies to control the money supply and thus the rate of inflation. The main policy tools used include:
- Money supply: the Central Bank can buy government bonds (increasing the money supply) or sell government bonds (decreasing the money supply)
- Money demand: the Central Bank can adjust (directly or indirectly) the interest rate that banks use to borrow and lend money to each other. This interest rate is called the “Federal Funds Rate” in the United States and the “overnight rate” in Canada. Lowering these interest rates typically has a cascading effect on other interest rates in the economy and can stimulate the economy by encouraging borrowing of money.
- Banking risk: the Central Bank can set the amount of reserves (cash on hand a bank must keep) which influences how much money banks can lend out, and thus adjust the money supply. Increasing the bank reserves requirements has the effect of decreasing the money supply, and thus slowing down inflation.
The figure below shows the Bank of Canada overnight interest rate from 2005 to 2015. As can be shown on the graph, the financial crisis of 2008 resulted in the Bank of Canada sharply reducing interest rates in an attempt to stimulate the economy.
The current overnight interest rate (since July 15, 2015) is at 0.5%. This is close to a zero percent interest rate, implying that there is a limited ability to further stimulate the economy more with this policy tool. This will be the subject of a future article.