What Are The Causes Of Inflation?

Inflation is a normal part of life, but as some countries show, if inflation levels change quickly or unexpectedly, the impact can be meaningful.

When I was a kid, my grandmother used to worry anytime she couldn’t make it to the corner store first thing in the morning, because she knew if she went later that day, the bread she was after would cost several hundred pesos more.

I didn’t get why that happened at the time, it was just the way things were.

That was Argentina in the 1980s, when growing government spending, high levels of foreign debt and the aftermath of a dictatorship and war led to levels of inflation that at one point briefly exceeded an annual rate of 1000 per cent.

As I write this in 2017, I’m reminded of my grandmother when I read about Venezuelans struggling with an inflation crisis that last year made consumer prices jump 800 per cent year-on-year and led to food shortages.

It’s a scenario that Zimbabwe lived through in 2008-2009, eventually causing the country stop printing its own currency altogether, and one Germany struggled with after losing World War I.

Yet in Canada, inflation has remained steady for the better part of two decades, with current estimates once again set at around two per cent.

The existence of inflation is an economic fact. It speaks to the relationship between the relative cost of goods and the value of money, and is defined as an increase in price for goods and services. As inflation goes up, every dollar you have buys less – think of what your grandparents would tell you they could buy with a nickel when they were kids, and what you can do with that now.

Why does inflation have so much more of a real impact on people’s lives in some places and not in others?

It partly comes down to monetary policy.

“Inflation is pretty much determined by an authority that controls the money supply, whether it’s directly by printing cash or by controlling the nominal interest rate,” said Thorsten Koeppl, an economics expert with Queen’s University.

In Canada, the Bank of Canada has a strong mandate to maintain the relative value of the country’s currency, but it does so independently and apart from the possible influence of politics. It has delivered on its promise of maintaining inflation at roughly two percent inflation for the last 25 years.

In the U.S. the Federal Reserve works in a similar away, although it has its own specific mandate.

That hasn’t always been the case in other parts of the world, however, at least during times when they experienced surges in inflation.

“In Germany, in 1923, the reason was the bank wasn’t independent and they had to pay reparation payments after the First World War, so … they tried to inflate the economy to get by,” said Koeppl.

“In other countries, like Venezuela, the tax system is not very efficient; there’s a big black market economy. How do you reach the black market economy? You basically tax it by high inflation.”

One of the problems in such cases is that it becomes difficult for people to plan ahead. If you know what the level of inflation will be, you should know what your savings or investments will be worth in 10 years’ time.

Inflation (also) hurts you more if you’ve got to do something now. This is one case where you better be in for the long term.

For instance, if you invest one dollar in a product that gives you a four per cent rate of return, and inflation is two per cent, you are actually getting a real return of two per cent. That’s the money you are left with to buy goods with.

But if while you’re planning your retirement (based on a two per cent return) inflation jumps to four per cent, you’ll find there’s suddenly a lot less you can afford.

“Inflation surprises redistribute returns in financial markets away from savers to borrowers,” Koeppl said. “Borrowers like inflation surprises because the real cost of borrowing goes down, whereas savers actually dislike inflation surprises because their real rate of return on savings goes down.”

Some investors turn to exchange-traded funds or real return bonds to deal with inflation, hoping these provide enough diversification to protect against possible inflationary hits.

But to Adrian Mastracci, a fee-only portfolio manager with Lycos Asset Management Inc. in Vancouver, it’s important to take a bigger-picture approach.

“What you probably have to do is step back, have a game plan, diversify your portfolio – you’re going to be right in some and not so right in others, depending on what inflation does,” said Mastracci.

“Inflation (also) hurts you more if you’ve got to do something now. This is one case where you better be in for the long term.”

In addition to inflationary surprises, inflation can also cause problems when it hits one of two extremes – deflation or hyperinflation.

Deflation makes prices fall, which makes paying back loans more expensive. Or, as Koeppl explains it, it means that “I’m buying one coffee (today) and I have to pay back two coffees tomorrow.”

Hyperinflation, on the other hand, means prices surge to unreasonable levels, which makes people buy anything they can get their hands on because everything will keep its value better than money. But spending that much that quickly also causes “all kinds of distortions” in the economy, Koeppl adds.

While inflation in North America is generally better controlled than in some other places, it’s still a measure to be aware of, and one that needs to be taken into account to keep your portfolio and savings on solid footing.

4 years ago