Fighting Inflation

Inflation refers to the amount (expressed in percentage terms) by which goods and services in an economy tend to increase year over year. Inflation, as measured in March 2020, stands at 1.5% in the UK and the US, and at over 50% in Argentina. The effect is that year over year, your £1 or $1 buys you 1.5% or 50% less than it did in the prior year.

Inflation is a natural side-effect of economic growth because it comes about when the demand for goods and services continually exceeds the supply of these goods and services ("too much money chasing too few goods"). It also arises when money is cheap to borrow (interest rates are low) and/or government's central banks "print" money as this, like economic growth, can also increase disposable income and thus demand for goods and services, which results in merchants putting up their prices.

It is in this way that inflation erodes the purchasing power of your money over time, though the actual amount of money staying the same. Unless the interest rate of your bank exceeds or at least matches the rate of inflation, the value of your money over time decreases. This may not be noticeable in the short-term but it sure will be over the long-term. To illustrate this, the price of a Cadbury "Freddo" chocolate bar was 10p in 2000, 25p by 2015, and will likely be around 40p in 2030. This is why your wages should also go up over time, and keep up with inflation. No all goods and services have increased in price equally, and some have even decreased in price (as a result of increased cost efficiency as discussed HERE). Inflation is just an average.

It is for this reason, as recently re-iterated by Warren Buffet at his annual shareholder meeting (April, 2020) that savings accounts and government bonds tend to be "terrible investment over time". Instead Buffett advocates owning stocks because as a stock owner you are also an owner of a share of the merchants business and income. So if prices go up due to inflation and you are invested in businesses that have this pricing power then that can protect you from inflation, as long as it is around 2% or lower. While some prices have evidently decreased in price, that however does not meant they have become less profitable for the business, they may have also become cheaper to produce than it was previously (it's all about margins).

This assertion should not be taken to mean that you should now jump into the stock market right away and invest all your savings. It just means that over a long period of time being invested in the stock market is more beneficial to your wealth than relying on your savings account for income, especially when inflation and interest rates are low. Investments by definition are long-term, so you should not have money in the stock market that you may need over the next 3-5 years. Nobody can predict what will happen in the short-term, but if history is a guide and Warren Buffett is right about the future of the U.S., there is still a lot of room for economic growth in the the future.

So if you want to be invested for the long-term, no need to make any rash decisions, but follow your chosen Investment Strategy as before.

NB: Given current events, governments all over the world are said to be "printing money", also known as "quantitive easing". What that means is that government's central banks are increasing the money supply available to institutions, banks, companies and individuals (to borrow). The idea is that this will increase liquidity in the economy to avoid mass credit defaults and bankruptcies.

In this way, the central banks are keeping economies from collapse (as they are right now). That extra liquidity is, governments hope, used to pay off debt, lend, spend and invest. The amount of money chasing goods therefore increases which stimulates the economy and hopefully end a recession. That is the intention anyway. A side-effect may be that prices of goods and services go up faster than anticipated, as the supply side cannot keep up with demand, including stocks (because where else would you be putting all that extra money).

This is why pumping money into the economy usually results in stock market rallies and how we can explain the current rally that started as soon as the central Bank of America (the Federal Reserve Bank) announced unlimited quantitative easing (QE) at the end of March. This is precisely why there is a saying on Wall Street that says "Don't Fight the FED" (short for the Federal Reserve Bank). It basically warns investors not to look at the real economy and how bad it might be but to focus on how much money there is available in the system, to predict where the stock market might go in the future.

The result is a stock market that is totally disconnected from the real economy. The hope is that the real economy will eventually catch up. People therefore often emphasises the distinction between "Main Street" (the real economy) and "Wall Street". Meaning the stock market is more often than NOT a reflection of the economy. The danger only arises when that gap persists for too long as the catch up never happens.

There have always been scenarios where government end up "printing" (it's a metaphor) so much money that it leads to hyperinflation where money essential becomes worthless. In the 1920s, Germany, for example, printed so much money because that was the only way they could pay for their WW1 debts, that money essentially became worthless to the extent that it was used as wallpaper and to make kites, and carried around in wheelbarrows to buy goods. Such hyperinflation obviously collapses economies and why injecting too much money into economies, isn't a good idea. But one way for governments going forward to pay for their debts incurred during the Coronavirus (Covid-19) is to increase inflation.