We all know that the price of goods and services increase over time. However, many of us don’t understand why or how those prices increase. In order to shed light on this subject, today we will be looking at the “hidden tax” called inflation.
A technical definition of inflation is ‘the quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time.’
Inflation is often presented as a percentage. As the percentage increases, purchasing power decreases. To better understand this, consider the price of an orange. If you are making $10 per hour in 2018 and 2019, but the price of an orange goes from $1.00 to $1.10, your overall purchasing power decreases by $0.10. You went from being able to purchase 10 organes/hour of work, to 9.09 oranges/hour of work.
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If after reading this article you want more information on inflation, you can also check out Are the Posted Inflation Rates a Lie?
In that article, we talk more about how inflation is calculated. However, in this article, we want to focus on why the government likes inflation, and the overall effect it has on you.
Why the Gov’t Loves Inflation
There are several key reasons why governments love inflation. In the short term, it can boost overall economic output and helps the government to justify increased tax rates.
However, these benefits only stay in effect until inflation catches up. Inflation is a lagging indicator. This means it takes a while for inflation to take effect once the money is deployed.
As we stated earlier, inflation is the measure of an increased cost of a basket of goods & services. One way that inflation is created is by an increase in the money supply.
An increase in the money supply comes in two forms. First, and most historically accurate, is the lowering of interest rates. As the central bank authority cuts interest rates, it trickles down to the consumer and the consumer can take out large loans and afford to pay more for things they wish to purchase, such as housing. Obviously, if there are more buyers with deeper pockets, it will inflate the price of real estate.
The second form of inflation is a bit more tricky. If the central banks have lowered interest rates as much as they feel comfortable doing, the second option is to create additional money supply through the printing of new money. As money is printed, the government can use that money to fund social programs and purchase goods and services for the upgrade of infrastructure.
The newly printed money enters the economy and is passed down to consumers through government purchases (funding social programs, infrastructure, etc). That is one way the government deploys the newly printed money. The more money the government deploys, the higher inflation will be.
Now that the money is in circulation, inflation will start catching up. So although there was a short term boost to the economy, the effects are short-lived.
Looking at long term reasons why the government likes inflation; it reduces a government’s debt repayment requirements.
Effects on Government Debt
As the government directs the central bank to print more money, the money that is currently in circulation, (aka. the money that the public holds) decreases in value. This is a simple economics principle – the more supply there is to meet demand, the lower the value of the item.
Debt behaves similar to money, in the sense that it is a promise to pay in the future. The same economic principle above can be applied to consumer and government debt.
If Canada borrows $5 billion from investors in the form of Canada Savings Bonds, then has the Bank of Canada print more money, when Canada repays those Canada Savings Bonds, they are doing so with new dollars created out of thin air. This makes it easier for Canada to repay its debt to those that hold its debt.
Inflation and interest Rates
As mentioned earlier, governments primarily use the lowering of interest rates to induce some healthy inflation and growth. However, interest rates can also be raised to slow inflation down if prices are climbing too fast.
This process is called monetary policy – monetary policy addresses interest rates and the supply of money in circulation.
Interest rates have an inverse relationship with inflation. If inflation is high, the government will increase interest rates in order to push it down. If inflation is low, they will decrease interest rates in order to help push it up.
Thus low interest rates mean higher inflation. High interest rates mean lower inflation. The government’s goal is to generally keep stated inflation at a rate between 1-3%.
This leads us to believe that there might be some missing information when looking at Canada’s current economic situation.
We currently have interest rates close to historically low levels, coupled with what we are told is average inflation. The Bank of Canada’s current overnight lending rate is 1.75%, while the prime rate is 3.95%. We are also told that the current inflation rate is 1.9%.
For more information on Prime Rate click here.
How is it possible that we have historically low interest rates with an average or lower than average inflation? Something doesn’t add up.
Since we know for a fact that interest rates are actually what we are told they are, we fix our eyes on inflation. Is it possible that the government and the BOC are not providing us with accurate information on inflation?
For more information on why we believe that inflation is higher than what is actually stated read: Inflation is Higher Than You Think
How Inflation Affects You
Let’s say that you’re a diligent saver. Your nest egg has grown to nearly $1.5 million. Great Job! That $1.5M is earning you 2.5% annually. A pretty decent rate for a fixed income product nowadays.
Furthermore, let’s say that inflation is 2% (what governments usually aim for). If the cost of everything went up by 2%, and your money only grew by 2.5%, your only ahead 0.5%. This means that year-over-year your purchasing power only increased by 0.5%.
But what happens if inflation is 6%? Or maybe even 8%? You guessed it! Your purchasing power actually dropped -3.5% or -5.5%. In order to maintain or increase your purchasing power, your returns must at the very least match inflation.
There is no way inflation would ever be that high though, right? If that’s what you think we would again suggest you read Inflation is Higher Than You Think.
On the other hand, one benefit of inflation is that it makes personal debt easier to repay. This occurs much the same as how we explained the effects on government debt.
As the government deploys the money, the consumers receive it, and this decreases the scarcity of money (higher wages, earning potential, etc). If money is less scarce and easier to earn, in turn, the consumer should have more money to pay back their fixed-value debts (less % of overall income going towards debt repayment).
However, now that debt is “easier” to pay off it can encourage people to take on more debt. Look around you today. More people are drowning in debt than ever before.
Furthermore, once inflation gets out of hand, interest rates will go up. This, in turn, increases the consumer debt burden.
But what happens if inflation stops?
What Happens If Inflation Stops?
Although moderate inflation (1%-2%) has some benefits, I’m sure we can all agree higher inflation is bad. If it is more realistically in the 6%+ range, what would happen if inflation were to stop and we enter deflation?
Well in the short term deflation is good for the consumer. It increases the purchasing power as prices fall and deleveraging debt becomes easier. But this is only temporary.
Soon companies will feel the effects of lower profit margins. They will be forced to decrease pay and/or lay workers off. This means that income starts declining, and unemployment begins to rise.
Lower-income combined with a higher unemployment rate means less consumer spending which heightens the effects on a company’s bottom line.
Oh, and let’s not forget about that debt we eagerly took on during times of inflation. Now that income is lower and unemployment is higher, meeting obligatory debt payments becomes more difficult. In the end, forcing more people to default on loans.
Although true moderate inflation has benefits, higher than average inflation can be detrimental to governments and consumers alike. Looking around us today it is no secret that inflation is higher than the stated 2%. We need the government to be honest and straightforward with us, but that also starts with us becoming more financially literate. Now that you know the effects inflation has, hopefully, you can see the effects of all their money printing.
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