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Inflation: A Monetary Phenomenon

August 29, 2022


How does Inflation Impact Me?
Inflation is not a new concept in the financial sector. In fact, it is something that is drilled into every finance student in college using the coined phrase, “a dollar today is worth more than a dollar tomorrow”. With the power of investments and earned interest, people can put their money to work and turn $1 into $100 given the appropriate investment and time frame. Therefore, it is natural for prices of goods and services to increase with the power of time and money. However, the rate of which these prices rise is not always lateral and is dependent on outside factors putting pressure on the markets. For example, in 2008-2009 inflation went from 3.84% to -0.36% (the first time inflation was at a negative in the past 60 years) due to the stock market crash and housing bubble pop. Today, it is no secret that in 2022, inflation is at a high not seen since “the Great Inflation” of the 1970’s, eroding many households’ purchasing power so that $100 of investment will only buy you $90 worth of goods. Investors have many questions and concerns related to this historic inflation, all boiling down to “how does this impact me and my investments?”.

What Causes Inflation?
Although the answer to this question is unique to each individual, before we can begin to determine the impact, first we must understand the causes of inflation. Milton Friedman famously wrote in his book Money Mischief: Episodes in Monetary History, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” This phenomenon was true in the 1970’s and it is true today, as well. During the height of the pandemic in 2020 when business owners and employees suffered a like, the government was attempting to keep the economy strong by introducing the CARES act. This act established the stimulus checks sent to taxpayers and also Payroll Protection loans for small businesses, among other COVID related relief. At the end of the day, the CARES Act established the $150 billion Coronavirus Relief Fund. Furthermore, during this time frame, interest rates continued to be at historic lows, with mortgage rates averaging 3.10% and 2.96% in 2020 and 2021, respectively. All of this resulted in a very rapid increase in the quantity of money held by the public. This alone would have caused inflation to increase year over year. However, at the same time we saw this increase in monetary power, the output (i.e., supply of goods and services) was also impacted.     

Since the world shut down in 2020, the supply chain for materials and labor has been disrupted. Plants both locally and globally have had to deal with periods of time with little or no work getting done due to COVID health protocols and employees refusing to come back to work. Furthermore, the companies then in charge of distribution once these goods are finished are also dealing with the same issues. Couple that with increased consumer demand after being couped up inside, with a stimulus check in hand, and companies just cannot keep up with output.  All of this being considered, near the end of 2021 the economy started to return to a more normal rhythm with more people being vaccinated and the fear of COVID subsiding. However, just when people saw “the light at the end of the tunnel”, Russia invaded Ukraine in February 2022 and all the supply chain issues increased tenfold.

How has the Russian War Impacted Inflation?
Although the primary focus of the Russian-Ukraine war should be the loss of human life and destruction of Ukrainian territory, the Russian invasion has created obstacles to an already fragile supply chain. Russia and Ukraine supply about a third of the world’s wheat, a quarter of the world’s barley, and about three fourths the world’s sunflower oil. However, with Russia’s ongoing warfare and export blockades, countries are suffering food shortages never seen before.  Another casualty of the war is the transportation corridor expanding from Russia to Poland and continuing on to Germany, France, and the rest of Europe. This route, responsible for the distribution of a significant amount of automotives and electronics, is now stalled. Finally, Russia is responsible for producing more oil than all but two countries. Therefore, when the war began, consumer demand immediately increased due to concerns of supply, which were then realized once the United States and other countries banned the import of Russian oil in retaliation of the war and supplies began to dimmish.

All of these aforementioned factors have created a perfect storm for inflation, which has reached a level of 9.060% year over year from June 2021 to June 2022. However, excluding energy and food costs which rose 41.6% and 10.4%, respectively, the Core CPI increased at a much lower 5.9%.

What can the Government do to Help?
To combat inflation, the government’s primary tool is to reduce the moneys in circulation, thus lowering demand, by selling bonds, changing tax laws, and raising interest rates. On June 1, 2022, the Federal Reserve initiated the process of reducing the size of its balance sheet (i.e., selling bonds) to address rising inflation by reducing bonds by $60 billion. In response to taxes, the government has had discussions over removing sales tax on gasoline and other goods, thereby reducing total cost of these items for consumers, but no changes have been made to date. The most significant change brought on by the government is raising interest rates. Thus far, the Federal Reserve has raised its benchmark interest rate four times this year. The latest of these being on July 27, 2022, for an additional three-quarters of a percentage point. Rate hikes at this pace and magnitude have not occurred since the late 1980’s. Despite these moves, the central bank has its work cut out for it, due to the Russian-Ukraine war and fragmented impacts of the pandemic still lingering, causing unnatural supply shortages. The government must rein in inflation but doing so risks kickstarting a recession in the United States.

Now Back to the Question at Hand, How does this Impact Investors?
First of all, rising interest rates have an inverse relationship on bonds. As rates rise, the price of bonds fall. This impact is most significant on long term bonds. Additionally, as the uncertainties around the impacts on supply chain continue from the Russian-Ukraine war, the stock markets will continue to be volatile. The good news is that these impacts are irregular and not within the normal course of market factors, so once they are resolved, we can expect inflation and the volatility within the market to decrease quickly and prices to rise once again. Now is the time to be patient and disciplined in the long-term model of investing to ride out these downturns. In fact, excluding the tech bubble burst in 2000-2002, historically, the average return for the calendar year following a negative return was a positive 24.5 percent. Therefore, the odds are pretty high that investors will recoup their losses from 2022 in the year or two to come.


Produced by the Investment Committee of the G5 Financial Group