There is no doubt that your preoccupations these days are your monthly budget cut, planning your grocery based on your necessities and not your cravings, following Instagram’s food trend ingredients, walking long distances instead of taking a taxi, and having anxiety about getting fired.
Well, you are not alone. Globally, inflation control has risen to the top of governments' agendas. They messed with the economy. Now-not them but us-we have to deal with the consequences. Governments and central banks' decisions lead us to this dark and dead-end tunnel. In our last article, we discussed the crazy work of central banks and their inability to control the money supply in a proper way. We also spoke about inflation, its causes and effects. Then, we briefly tried to link all the boring-to a certain extent-theoretical talk to our current economic situation. In this article, we will try to understand how inflation affects our personal tiny (or large) investments and how it affects our communities. So, let’s get started!
How bad can inflation affect you
Inflation eats into your wealth like a worm. As time passes, inflation can erode your wealth by chipping away at the purchasing power of your money. Inflation can easily and silently destroy your wallet. We can illustrate the meticulously dangerous work of inflation as follows: I imagine that you are keeping $200 somewhere in your wardrobe for an emergency. Let’s suppose that the annual inflation rate is 5%. By the end of the year, your $200 would be worth $190. NOW, imagine the cumulative result after 10 years!
Another way of explaining this phenomenon is that the rate of inflation represents the pace at which the real value of your wealth is diminished after a certain period. With this idea in mind, inflation affects assets and investments in different ways. As different assets have distinct market characteristics, they react differently to high inflation. Now, imagine with me: some plants bloom and give fruits in spring and summer, some others in winter; all depend on the weather and the plant's characteristics. Well, in economics, the situation is pretty much the same. The general condition of the economy is that the weather and asset characteristics are plant characteristics. Hence, some assets bloom during economic turmoil – winter- like gold and some bloom during the market’s good days – spring- like stocks.
- They go with the flow: Liquid assets
Since liquid assets-cash essentially-tend to lose value quickly over time, they are negatively and strongly impacted by inflation. Besides, it's not just liquid assets that lose value; inflation also impacts illiquid assets, yet these can be relatively protected if they generate profit (it can be interest, dividend, or returns) or increase in value.
- The Mirage of Savings accounts
Some people think that putting their money into a savings account will shield their wealth from the negative impact of inflation because it generates interest. However, saving accounts usually have low interest rates, which will lead to a diminished value of their savings. Why? Well, during periods of high inflation, the generated interest is consumed by the decline in value. Generally, placements, investments, or assets that generate interest or a fixed return will see declining returns in real value during periods of high inflation.
- A punch in the jaw for pension savers
This is one of the most dangerous parts of the inflation saga. Pension savers may underestimate the destructive effect inflation can have on their savings and their retirement plans. Pension funds are where inflation can cause a dramatic loss. Imagine someone who has been working hard for years, saving for their retirement, and then, within a few months (or years), they lose most of their valuable savings. The primary concern of pension savers must be the recognition of what their savings may be worth when the time comes for them to retire. Hence, unless their investment achieves returns greater than the inflation rate, the value of their pension will keep bleeding to death.
- The fake shield: Fixed income investments
Bonds are an important component for a balanced portfolio; this is what a traditional financial expert would tell you if you asked. Risk-free assets are there to protect you, they say, from the risk and provide a stable income stream. However, dear readers, you should keep in mind that bond prices fall when the monster — inflation — rises from the ashes. Let me explain. Generally, bonds keep the same interest rate until maturity. However, the rate of inflation keeps increasing. As a result, as inflation rises, the purchasing power of interest income falls.
- Debunking the urban myth: The Almighty stock market
Some financial gurus believe that during inflationary periods, markets can move. According to them, your stock returns can stay ahead of inflation if you can manage to not follow the herd and panic sell. These gurus claim that a diversified portfolio containing equities will-with some expected difficulties-shields you against inflation. However, world-class economist Eugene Fama, the 2013 Nobel laureate, states that high inflation causes the slowdown of real economic activity, which will negatively impact future corporate profits and, subsequently, the prices of stocks [1].
- A fragile socio-economic situation
The worst thing about inflation when it hits is the social challenges it creates. The fear we have to face, the houses we have to leave. The lifelong dreams we have to let go. The needs that we no longer meet. Rising prices hurt the middle and lower classes in a society. Inflation decreases the real income of individuals. People would no longer be able to pay their debts, their bills, and their general living expenses like transportation, health, and education. Under the current circumstances, a lot of people are being kicked out of their houses because they can’t afford to pay their mortgages or the insanely increasing rents. Besides, during periods of high inflation, unemployment increases for two reasons: first, due to the economic slowdown, companies no longer hire people. Second, due to higher expenses, a lot of companies fire a considerable number of their workers. In some cases, inflation would turn some neighbourhoods and districts into unsafe places; crime and delinquency would increase, and the moral code would no longer exist if human dignity is not preserved. A man need not worry about his food and shelter. It doesn’t stop there. Social challenges created by inflation can lead to political instability. Simply put, people cannot endure despair or leave a stressful life because of tight budgets for a prolonged period.
Now that we understand inflation, its causes, and consequences, how can we protect our wealth? Stay tuned; new articles on inflation are coming soon.
References
[1] E. Fama, «Stock Returns, Real Activity, Inflation, and Money,» The American Economic Review , vol. 71, n° 14, p. 545–565, 1981.
