Types of Inflation

November 29, 20228 min read
Types of Inflation
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Key Takeaways

• Inflation, referred to as a general rise in the prices of goods and services, can take one of three forms. 

• Monetary authorities usually increase the costs of borrowing during severe inflationary periods to bring prices down.

• We believe the best defense of wealth against inflation are investment vehicles whose returns hold the potential to defeat it.

As this is being written, for the first time in four decades, the level of inflation has become a real economic concern. Broadly, inflation is referred to as a rise in prices of goods and services, which actually tends to naturally occur — albeit gradually. The difference now is that inflation is occurring at a rate that is far beyond gradual. In fact, prices have spiked by over 10% during the 12 months prior to this article’s composition. This is in sharp contrast to the more typical 2% per year. 

What Exactly is Inflation?

As indicated above, inflation is a rise in prices, or said more precisely, a decline in the purchasing power of any given currency. This is because a rise in prices effectively reduces the value of a currency. The opposite of inflation is deflation, which happens when prices retreat and purchasing power expands. 

Consumers tend to experience this most acutely because the prices of basic necessities such as fuel, food, utilities, health care, entertainment and transportation all go up simultaneously. This rise in prices tends to suppress demand, which in turn slows economic growth. 

Causes of Inflation

The theory of supply and demand suggests that inflation happens when there are more dollars in the economy chasing fewer goods and services. In other words, when consumers have a lot of money to spend, but supplies don’t increase commensurately, prices increase. Conversely, prices are reduced when supplies are plentiful as an incentive to drive purchases.

To that end, monetary authorities such as the United States Federal Reserve will increase the costs of borrowing during severe inflationary periods to slow the rate of consumption to bring prices down. 

While an increase in the money supply is one of the most common causes of inflation, the phenomenon can also result from an intentional devaluation of a currency. A government purchasing its bonds from banks on the secondary market can also have the effect of pumping new money into the system. In each case, the overall purchasing power of the currency in question will suffer.

Can Inflation Be Predicted?

While it is possible to foresee what the potential certain economic climates hold for increasing the rate of inflation, predicting it has yet to prove to be an exact science. Take this current inflationary period for example. One of the most visible aspects of it was the sharp increase in the prices of a gallon of gasoline. 

Because of this, experts predicted inflation would slow when gas prices retreated. So far, that has to materialize, even though gas prices are down considerably from their peak in the summer of 2022. Other experts predicted that inflation would ease as the artificially induced supply chain issues resulting from the worldwide COVID-19 quarantines eased. They have largely been resolved and inflation persists just the same.

Contributing to the unpredictability of inflation is the fact that the prices of so many of the commodities by which inflation is measured are unpredictable. Sharp increases in the prices of oil, natural gas and corn will ripple throughout the economy because the production of so many goods — and the performance of so many services — are reliant upon them.

Another factor rendering inflation difficult to forecast is the wide variety of factors that can feed it. Currently, these include Russia’s attack upon Ukraine, the aforementioned supply chain problems, the Federal Reserve’s monetary policy, labor shortages and wage growth. What’s more, every economy in the developed world is being affected.

Types of Inflation

There are three basic varieties of inflation. 

Demand-pull inflation occurs when demand is high for a given product or service. A coffee shop will raise its prices when a proprietor realizes they have an exceedingly long line of customers who don’t really care what a cup costs.

Cost-push inflation results when the prices of raw materials increase and force manufacturers to raise prices to offset the additional cost of production this imposes. This, in turn, causes sellers to raise prices to maintain their profit margins. A hike in the price of coffee beans means a coffee shop is going to have to raise prices to compensate. 

Built-in inflation can result when wage increases are mandated so that employers can retain labor forces. Forced to increase wages, businesses must then increase prices to maintain their profit margins. When a coffee shop also has to pay baristas more, that added cost is brewed into each cup. 

The economy is currently in a situation in which demand for just about everything is high, the prices of raw materials have gone up significantly, and workers are demanding better pay. In other words, all three types of inflation are happening at once.

Measuring Inflation

There are two primary indices by which the measurement of inflation is accomplished. The Consumer Price Index (CPI) is employed by the U.S. Bureau of Labor Statistics to track the ebbs and flows of inflation. The other metric used to measure inflation is the Personal Consumption Expenditure Price Index (PCE).

The costs of some 80,000 goods and services are monitored to determine the CPI. These include food, fuel, and clothing, as well as expenses such as daycare and preschool costs along with college tuition and funeral expenses. When you see a quote, or hear it stated that prices have increased by a certain number of percentage points over a given period of time, the average percentage of change of the price of the items monitored by the CPI is being cited. 

The PCE works largely the same, except that it considers all the items Americans purchase, not just those that are typically considered out-of-pocket expenditures. Further, the PCE also looks at what businesses are selling. For example, while the CPI tracks medical service expenses paid for by consumers, the PCE goes on to consider the costs of providing health care services as paid for by an employer-sponsored health insurance plan, Medicare or Medicaid.

Of the two, the Federal Reserve considers the Personal Consumption Expenditure Price Index a more reliable bellwether. Based upon these metrics, the Federal Reserve will decide whether it is prudent to raise interest rates to help curb spending. However, the Fed must be careful to enact increases gradually in order to avoid stopping borrowing activity completely. This could trigger a prolonged widespread downturn in the economy — also known as a recession.

Hedging Against Inflation

People concerned about the effect inflation can have on their wealth have several strategies available to prevent the erosion of their purchasing power.  

Moving money into a high-yield savings account will help liquid funds earn more interest than they would in a traditional savings account (typically 1.5% vs 0.1%). While this approach won’t match the rate of inflation, it will help keep it at bay, while preserving the flexibility a household emergency fund requires.

Treasury bonds are another type of investment vehicle with which the effects of inflation can potentially be mitigated.  U.S. Savings Bonds have a rate of 9.62%, which is currently greater than the rate of inflation. Treasury Inflation-Protected Securities are indexed to inflation, so their yields adjust in sync with inflation.

Publicly traded equities such as stocks can also be useful in this regard. The stock market has historically returned some 12.3% annually over the past 95 years. This exceeds the rate of inflation. 

Portfolio diversification can help lower the degree of risk an investment portfolio encounters. Diversification spreads the risk across a number of different companies, so downturns in some investments might be offset by upticks in others.

Portfolio Diversification and Alternative Investments

Alternative investments hold the potential to be useful tools for portfolio diversification. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to recessions. 

Real estate, private equity, venture capital, digital assets and collectibles are among the asset classes deemed “alternative investments.” Such investments tend to be less connected to public equity, and thus offer potential for diversification. With that said, they also entail a degree of risk commensurate with their potential to deliver rewards. 

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of this magnitude, should an investment of this nature underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While it’s true the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $5,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

While inflation is a natural economic occurrence, there are certain periods when its rate of expansion exceeds what is considered normal. This can be triggered by a number of different causes, all of which are in play simultaneously as this is being written. The best defense of wealth during an excessive inflationary period is taking positions in one or more of a number of investments whose returns hold the potential to minimize the effects of currency devaluation, or defeat it altogether. 

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