By Professor Ricardo Ulivi, Ph.D.
March 2018
A simple definition of inflation is that it’s too much money chasing too few goods. Here’s an example: If you only have $1, the most you can bid for a cup of coffee is $1. However, if suddenly I put another dollar in your pocket, you can now bid up to $2 for the same cup of coffee. In other words, the price went up even though the amount of coffee is the same. That’s inflation.
Too much money?
What causes inflation? Although it is a complex issue, most economists agree that a major cause of inflation is a government printing too much money. Why does it print money? When it runs deficits, it still needs to pay its bills. To get money for this, a government normally sells bonds to the public, or worst of all, to its Federal Reserve or central bank. It, in turn, obtains the necessary money to buy the government bonds by printing new currency. This is how excess money gets into an economy, which in turn fuels the inflation fire.
Conclusion: Beware of governments that run large fiscal deficits.
Too few goods?
Printing too much money is a problem, but having a closed economy, where imports are severely restricted, as a way to protect local manufacturing, compounds the problem. Argentina is an excellent example of this. It has “enjoyed” a closed economy for nearly 70 years, and has had government deficits for as long. The result? Inflation that is rarely below 20% per year, with a hyperinflation period included.
Conclusion: Combining deficit spending with a closed economy results in very high inflation.
Where’s inflation headed in the US?
We all know that the US Government has been running huge deficits for too long, and that it is embarking on producing even bigger ones now and in the foreseeable future. In other words, we are facing the first component of inflation: the printing of too much money due to deficit spending.
Why hasn’t inflation accelerated, at least until now? The answer is that we are a very “open” economy, so if domestic manufacturers cannot produce enough, we import, and do we! The Chinese, Germans, Mexicans and others flood us with goods, so the excess demand produced by printing too much money does not result in higher prices thanks to imports. But these massive imports cause a huge trade deficit, which should lower the value of the dollar. This has already begun to occur, and it will be another element adding fuel to inflation because a depreciating dollar makes imports more expensive.
However, aside from a falling dollar, we have the Trump administration starting to “close” our economy, and this should result in higher prices too. For example, it recently imposed a 20% to 50% tariff on imported washing machines. It did the same with solar panels, and it is studying doing the same with steel and aluminum imports.
Conclusion: inflation is likely to accelerate in the USA.
How to protect yourself from the coming inflation spiral
With inflation beginning to increase, you can expect interest rates to rise as well. Therefore, the value of bonds will drop, and because mortgages rates will also increase, the value of real estate will fall. The same should happen to stock prices.
If you want to attempt to gain from the coming inflation increase, at least in the short run, you can consider investing in commodities because these tend to be priced in dollars. As the value of the dollar falls, commodity prices should increase to maintain their real value. Owning some foreign currencies may also be an effective way to protect the purchasing power of your assets.
In the long run, both stocks and real estate are very good hedges against inflation. Why? When inflation accelerates, it is usually un-anticipated, which means that input prices tend to go up faster than business people realize, hurting profits, and stock and real estate prices. With time, however, businesses adjust and start raising their prices too, restoring profit margins. A similar effect occurs with real estate; rents initially don’t go up as fast as inflation, but given enough time, landlords realize what’s happening, and they start increasing rents to match or exceed inflation. Thus, stocks and real estate tend to maintain their real value over the long term.
Don’t forget to protect your wealth against the ravages of inflation! Need help? Contact me by calling me at 714-771-6000
