Would you want $1,000,000 today or $1,000 every day for the next 1,000 days? If you selected the 1,000,000 today, one of the reasons why you might have chosen $1 million today is because you know that what you can get for $1,000 today, you might need more money to get it in 3 years.....
This phenomenon is what is called the "time value of money".
Time value of money means that money today is worth more than the same amount of money in the future. It would cost you more money in the future to buy the same things you are buying today. That is, all things being equal, $100 today will be worth more than $100 in 10 years because while $100 would still be $100, in 10 years, the price of goods and services would go up.
Why does this happen? Because of something called INFLATION. Inflation is simply a reduction in the purchasing power of money. That is, inflation is what makes it more expensive to pay for something in the future. For example, if the inflation rate of a country is 10%, this means on average what you bought for $100 today would cost you $110 to buy a year from today.
The Central Bank of every country typically sets its target inflation rate. For example, The US Federal Reserve (the US Central Bank) sets its inflation target at 2%. Recently, the Chairman of the US Federal Reserve (the Fed), Jerome Powell announced that the Fed would be willing to allow inflation run higher than normal because "inflation that is persistently too low can pose serious risks to the economy."The average inflation of the US has been around 1.69% (including 2020 average recorded inflation year to date) and 1.759% (excluding 2020). This means that to achieve the target 2% inflation rate over the last 10 years, inflation can go as high as 2.41%. Dallas Fed President Robert Kaplan told CNBC that he would be content with a range of around 2.25%-2.5%.
What does this mean? How can low inflation be harmful? How can prices rising (inflation) be a good thing? Shouldn't we want things to be cheaper?
Should we want things to be cheaper? Should we want deflation?
Deflation is simply a situation where your money is worth more in the future than it is today or the purchasing power of money is higher in the future. That is, the longer you wait to buy something, the cheaper it becomes.
Should we want deflation? The short answer is no. But why?
If you knew that something you wanted to buy today would be cheaper next week (if you don't need it urgently), would you buy it today or wait till next week to buy it when it's cheaper? All things being equal, the rational spender would wait. And that is what happens during deflation. Since we all know that the prices of goods would continue going down, people stop spending. Like a domino effect, as more people stop spending (demand falls), it causes prices to fall too. So the cycle is, people stop spending because they expect prices to fall, as fewer people demand a good, the prices fall, and the cycle continues.
Here's where the catch comes. As the prices continue falling, businesses would have to reduce production or sell fewer goods because fewer people are buying. If businesses sell fewer goods, they would have to reduce their employees, which causes people to lose their jobs and as more people lose their jobs, they would have less money to spend because they are no longer earning money. And so continues the vicious cycle of persistent deflation that will send a country into a deep recession. This is why governments act to prevent deflation.
So no, we don't want deflation.
But how can low inflation be harmful?
It is simple, stable and consistent inflation means the economy is growing. If inflation is low, it means the economy is not growing as well as we would want it to. Countries want their economy to grow at a steady rate. This is why they set inflation expectations and try to meet those expectations every year.
Also, one of the reasons people spend money is because they know that what they want to buy might be more expensive in the future. If inflation is very low or 0%, that incentive would be taken away. People can wait to buy something, and this waiting might take us somewhere on the road to deflation.
How can you benefit from inflation?
For investors, this means that the value of your investments could go up. This is because assets prices like stock and real estate go up as inflation goes up. This happens for several reasons, but here's a general idea: as the prices of goods and services go up and people spend more money, this allows for money to circulate in the economy and cause the economy to grow. A growing economy is a good signal to invest. Also, when interest rates are low like they are currently in the US, it makes it cheaper to get loans to buy houses and more money to buy houses = more people can demand houses = higher prices.
PS: this does not mean all stock prices would go up, it just means on average this is typically what happens
Loan balances become cheaper to pay off: Remember the definition of inflation, the reduction in the purchasing power or value of money. If for example, a homeowner can secure a 2% fixed-rate mortgage for 30 years, if inflation rises to 3%, this means that the loan is practically cheaper by 1%.
This is also one of the reasons why it makes sense for the government to keep its national debt for so long. The longer they keep the debt, the lower the real value of money they have to pay. With interest rates close to almost zero in the US, the national debt costs almost nothing to keep. As time passes, inflation will continue to eat at the debt, making it cheaper and cheaper. For example, the US national debt is currently at about $27 trillion, in 100 years, if there is no additional debt, the value of the $27 trillion debt would be around $3.7 trillion. While they would effectively still pay the same amount ($27 trillion), the value of the money they would pay would be A LOT less. It would be like borrowing 100,000 today and paying 10,000 in the future. It's an EXCELLENT deal for the borrower.In summary, the people that win from inflation are those that can borrow low-interest-rate loans over a long time to invest in assets or businesses that are growing. This is one of the reasons why you hear that a lot of rich people borrow A LOT. Borrowing/Leverage is a great tool to grow wealth (I will talk more about this in the next article on this newsletter, subscribe so you can be notified when I upload the article)
Who is inflation bad for?
Inflation is bad for those that are not investing. If you are only saving your money, you would be losing more value for your money as time passes especially since interest rates are so low. In this post, I compare saving to investment and explain which is best to do in every situation.
PS: this does not mean you should rush to invest without understanding how investments work, that would be a bad strategy. This post explains what you should do if you are considering investing in the stock market. You can also get more information about topics like gold, cryptocurrency and forex.
But does this mean that very high inflation (hyperinflation) is good?
Also no. Because when inflation is too high, it makes money worthless. Remember that the reason why the time value of money is a thing is that while our money remains the same, the price of goods and services go up. Hyperinflation is a situation where the price of goods and services go up significantly that you would need A LOT of money to buy something. A popular recent example of this was in the case of Zimbabwe, where the price of goods got so high that they had to print a $100 trillion bill.Final Words:
Inflation, good
Too much of it, bad.
Too little of it or no inflation or deflation, also bad.
Inflation needs to be just right and controlled.
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