Tuesday, 7 March 2017

Inflation: Causes, Effects & Mitigation

  • Inflation is the long term rise in the prices of goods and services due to currency devaluation. 
  • The effects of inflation are both gradual and profound. 
  • Inflation creeps up on us and as we continue our normal spending and consumption habits, the increase of consumer prices doesn’t seem to make a huge difference in our day to day finances.
  • Food prices go up, transportation prices increase, petrol prices rise, and the cost of various other goods and services skyrocket over time. All of these factors impacts your long-term savings and ability to fund your retirement planning.
  • Inflationary problems arise when it is not matched by a rise in income. If incomes do not increase along with the prices of goods, everyone’s purchasing power gets reduced, leading to a slowing or stagnant economy. 
  • Excessive inflation can also wreak havoc on retirement savings as it reduces the purchasing power of the money that savers and investors have squirreled away.
  • Inflation is caused by increased money supply outpacing economic growth.
  • Ever since nations moved away from the gold standard, the value of money is determined by the amount of currency that is in circulation and the public’s perception of the value of that money. When more money is put into circulation at a rate higher than the economy’s growth rate, the value of money can fall because of the changing public perception of the value of the underlying currency. This devaluation will force prices to rise due to the fact that each unit of currency is now worth less.
  • A macroeconomic way of looking at the negative effects of an increased money supply is that there will be more currency chasing the same amount of goods in an economy, which will lead to increased demand and therefore higher prices.
  • High national debt is a bad thing actually drives inflation to higher levels over time. As a country’s debt increases, the government can either raise taxes or print more money to pay off the debt.
  • A rise in taxes will force businesses to raise their prices. 
  • Government printing more money will lead directly to an increase in the money supply, which will in turn lead to the devaluation of the currency and increased prices.
  • As wages increase within an economic system in a growing economy people will have more money to spend on consumer goods. This increase in liquidity and demand for consumer goods results in an increase in demand for products and companies will raise prices to the level the consumer will bear in order to balance supply and demand.
  • When companies are faced with increased input costs of raw materials or wages, they will preserve their profitability by passing this increased cost of production onto the consumer in the form of higher prices.
  • Inflation can be made worse by our increasing exposure to foreign marketplaces. In global economy, exchange rates are one of the most important factors in determining our rate of inflation. When exchange rate suffers imports become expensive and exports cheaper.
  • Economists argue that a healthy rate of inflation is considered to be approximately 2-3% per year. The goal is for inflation to outpace the growth of the underlying economy by a small amount per year. 
  • A healthy rate of inflation is considered a positive because it results in increasing wages and corporate profitability and keeps capital flowing in a presumably growing economy. As long as things are moving in relative unison, inflation will not be detrimental.
  • Small amounts of inflation encourages consumption which can further stimulate the economy and create more jobs.
  • When it comes to long-term investments, sometimes spending money now can allow you to benefit from inflation down the road. Mortgage to purchase a home when you consider you can repay the mortgage down the line with inflated dollars that are worth less than they are now, then you are using inflation to your benefit. Other areas where you can take advantage of inflation include home improvement projects, capex for a business, or major investments.
  • Commodities have an inherent worth that is resilient to inflation. Unlike money, commodities will always remain in demand and can act as an excellent hedge against inflation. In case purchasing commodities is a daunting task, you can consider commodity-based Exchange Traded Funds (ETFs) which offer the liquidity of stocks with the inflation hedging power of commodity investments. Just be careful of the problems of ETFs.
  • Gold, silver, and other precious metals also have an inherent value that allows them to remain immune to inflation. In fact, gold used to be the preferred form of currency before the move to paper currency took place. With that said, even precious metals are liable to being a part of speculative bubbles.
  • Real estate offers an inflationary hedge. Investing in real estate provides a real asset. Rental property can offer the landlord the option of increasing rent prices over time to keep pace with inflation. The added ability to sell the real assets in the open market for a return that generally keeps pace with or outstrips inflation. However we all know that real estate bubbles can and do exist.
  • Equities have historically beat bonds because of the ability of corporations to pass price increases along to their consumers, resulting in higher income and returns for both the company and its investors.
  • Large cap, dividend paying stocks have provided an inflation-adjusted 7% per year for long term investors. If you have the investment risk tolerance for the volatility and a time horizon of greater than 20 years until retirement, consider dividend-paying securities. Dividend stocks offer a hedge against inflation because dividends normally increase on an annual basis at a rate which outpaces that of inflation. 
  • You are probably need a lot more money for retirement than you think you will. There are two ways to get to your new benchmark: Save more, or invest more aggressively. Saving more is probably the easiest and most proactive thing you can do to ensure your ability to fund a comfortable retirement. 
  • Like it or not, inflation is real. Ignoring the effects that inflation can and will have on your long-term savings is probably one of the biggest mistakes that many investors make. Understand the detrimental causes and effects of inflation to make long-term decisions to mitigate the risks. Consider the above tips to overcome the devastating effects inflation can have on your future retirement.
My View:
In India, inflation is primarily caused by RBI printing more currency to meet the revenue deficits of central government arising due to tax evasion, black money & corruption. In 1947 USD and INR were at par and today in 2017 it is Rs.67 per USD. Some years inflation was in excess of 10% thus hurting wage earners and salaried class people most. Governments tend to believe that printing currency is a matter of right which is in other words is another worst from of indirect tax effecting essential commodities and poor as well. Inflation impoverishes savers and enriches borrowers, which is an absurd. National debt and external borrowings have crossed manageable levels and thus ratings reached near junk status and effecting foreign investments. Irrational taxation and poor monitoring systems has resulted in rich people maintaining their wealth in foreign countries illegally effecting our economy. Even though reforms are conceived 25 years ago, distortions, abuse and politics have resulted in benefits for only upper classes while others mostly rural habitants and uneducated remained poor. In the absence of political will & bureaucratic honesty and rampant greed, elimination of poverty and economic prosperity for all is a distant mirage. Worst, inflation can be viewed as government robbing away your wealth and earnings.

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