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What is inflation?
Inflation is the decline in purchasing power of the currency or medium of exchange used to purchase goods and services, resulting in increased prices of said goods and services. In the US, inflation is the decline in purchasing power of the US dollar (USD) and subsequent increase in the cost of living for American consumers. Inflation can affect a variety of goods and services and does not always affect everything equally. In general, inflation is caused by an increase in the supply of money in an economy. Money supply can be increased by printing and distributing money to individuals and by loaning new money into existence as reserve account credits through the banking system.
How is inflation measured?
Inflation is typically measured and reported by central agencies. In the U.S., “official” inflation metrics are captured and reported by the Federal Reserve and made available to the public via FRED (Federal Reserve Economic Data) database. The most popular metric used to capture inflation in the U.S. is the Consumer Price Index (CPI), which takes into account average prices of a basket of goods meant to represent primary consumer needs (including food, transportation, medical care). It is common to report CPI as a percentage change from month to month or year over year.
You’ll notice that I added quotation marks to the word “official” above - I did this because many argue that metrics like the CPI fail to take into account many important items like housing (mortgage and rent). Because of this, CPI very likely underestimates true inflation experienced by Americans.
Current state of our economy (November 2021)
If you’ve been paying attention to headlines over the last several months, you’ve almost certainly seen that we’re currently experiencing high levels of inflation. Indeed, CPI rose 6.2% in October 2021 versus October 2020 - that’s the highest year over year increase in over 30 years.
The current spike in inflation is caused in large part by the economic policymaking that occurred during the COVID-19 pandemic. Many states completely locked down their economies for prolonged periods of time, causing massive job losses, permanent business closures, and a drop in economic output. On top of this, the money supply skyrocketed - this can be seen in the FRED chart below (M2 offers a general view of money supply in the U.S.; note the y-axis is in billions).
Unfortunately, there is no end in sight. Despite the fact that ~40% of all USD in existence was printed in the last 12 months, the US government continues to pass trillion dollar spending bills. Simply put, they’re adding to the national debt by spending money that they don’t have and will not be able to fully recoup from taxes. Although we’re far from hyperinflation (according to Investopedia, “hyperinflation is out-of-control inflation, in which the price of goods and services rises at an annual rate of 1,000% or more”), there is no question that we are experiencing relatively high levels of inflation and USD debasement.
How to invest during periods of high inflation
In a macro-environment hit hard by inflation, it’s important for investors to park their money in assets that serve as strong stores of value. That is, if the USD is declining in value over time, you should spend USD on assets that hold, or even better, increase their value over time. Traditionally, investors used precious metals like gold and silver as inflationary hedges. However, the growing popularity of Bitcoin (referred to by some as “digital gold” or “gold 2.0”) has many questioning whether BTC has replaced precious metals as the best hedge against inflation. In our last State of the Coin newsletter, we found a strong positive correlation between Bitcoin value and CPI over the last 22 months - as inflation worsened, BTC became more valuable. Over the last 12 months, on the other hand, the correlation between gold and CPI was negative (R = -0.41) - as inflation worsened over the last year, gold became less valuable! During the worst bout of inflation in 3 decades, gold is failing to serve as a store of value.
In this article we provided a very (very) basic overview of inflation. For a more in-depth look at inflation, check out a great article from Investopedia here.
If you’re new to stock investing, check out our introduction to stock investing series:
If you’re new to real estate investing, check out our real estate investing series:
Have a great rest of your week!
Brandon & Dan
Disclosure: The article was written by Daniel Kuhman and Brandon Keys, and it expresses the author's own opinions. The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock, asset, or cryptocurrency. Brandon and Daniel are not financial advisors. We encourage all readers to do further research and do your own due diligence before making any investments.