#60A- What is Inflation and How Does it Effect the Economy and the Stock Market?

Updated: Jun 11

-What causes inflation?

-What is the M2 money supply?

-The money that has been injected in the financial system

-Investing in an inflationary environment

-Inflation financial tips recap

I think we should provide a basic scenario on what inflation is, and then talk about how to combat it. So this might be easy to visualize when we relate it to coffee: the price in 1970 was 25 cents per cup and by 2019 it was $1.59. That’s over a 600% increase.

So let’s first talk about it. What is Inflation?

Inflation is a general rise in the price level in an economy over a period of time. As prices rise, the strength of the currency declines. (In our case, the US dollar) Hence, each unit of a 2% annual inflation rate means that, on average, a dollar buys 2% fewer goods and services than it did the year before. The consumer price index (CPI) measures the average change over time in the prices paid by consumers for a market basket of consumer goods and services.

What Causes Inflation

Increases in production costs including materials and wages. This is known as cost-push inflation. For example, the state of the housing industry has experienced shortages with lumber, steel and copper (5/26/21), and also we talked about the auto industry facing shortages with chips.

Chlorine has been in short supply as a Louisiana production facility experienced a fire last year. Pet food is on the rise due to pet adoptions and breeding. Moreover, chicken wings have been flying off the shelves as they are pandemic proof coupled with the storms in Texas. Here’s the bottom line: As long as consumers are willing to pay more for the products, the prices for goods and services will remain higher.

Here’s the other scenario: when the consumer demand increases for a product or service. When there's a surge in demand for goods across an economy, prices increase, and the result is demand-pull inflation.

Another important indicator that economists look at is the M2 Money supply. It measures cash, checking deposits, and easily convertible and highly liquid “near money.” The velocity of money is a measurement of the rate at which money is exchanged in an economy. High money velocity is usually associated with a healthy, expanding economy.

-M1 measures cash and checking deposits,

-M2 is used to monitor money supply and future inflation by the central bank monetary policy.

In 2020, the M2 supply jumped from $15.51 trillion in February right before the COVID-19 pandemic to $18.45 trillion in August 2020, well into the pandemic, which was a jump of nearly 19%. The reason for the increase is that it was reflecting the tough economic period and the Federal Reserve's actions to cut interest rates to near historic lows and increased the money supply overall with the stimulus packages. Interest rates are often referred to as the cost of money. There were three rounds of stimulus checks and several months of unemployment. In addition, student loan payments have been deferred so some people may have spent that money elsewhere.

Too Many Dollars in the Financial System

So lets say Inflation happens when there are too many dollars floating about in the monetary system. When the supply of dollars exceeds the supply of goods to buy, each dollar is worth less, so the prices of those goods increase.

Basically, the amount of money in an economy is referred to as the money supply. This consists of far more than physical money floating around, and in fact, the physical money makes up less than one-tenth of all the money in a typical, developed economy.

Keep in mind, the rest of the money in the economy is virtual. Think about the thing people don’t consider is that the unused lines of credit in your credit card accounts, or in large corporation's commercial bank accounts - they are also used to assess part of the money supply, because these can be used just as readily as bills and coins to buy goods and services.

Economists always keep a close eye on money supply, because this figure determines the purchasing power and therefore, potential demand for products and services.

In addition, the reason stocks do well when the money supply is high is the increase in general demand in the economy. When the borrowing rates are low, mortgage rates also decline making homes more affordable.

With the extremely low housing inventory, and historic low interest rates and high amounts of cash on hand, this increases the demand for such items as TV sets, washing machines and so on.

Car sales also go up when the financing rates drop. The lower rates partially trickle down to interest rates charged on credit card purchases, and consumers purchase more of every imaginable good and service. The result in increased sales for most companies, which increases profits and usually results in higher stock prices.

Keep an Eye out for Oil

Oil has the biggest impact on inflation as it is directly related to fueling cars, planes and manufacturing process. In addition, many products are made from petroleum including plastics, synthetic materials and chemicals products.

Moreover, the summer season is known as the driving season and drivers in large countries including the United States and China are about to consume more fuel. (May, 2021). Keep in mind that oil can rise even if the supply is ample and there is always market manipulation.

How Do We Invest In an Inflationary Environment?

So how do we invest during this time? The primary benefit of investing during inflation, of course, is to preserve our portfolio's buying power. The second reason we want to keep that nest egg growing during these times because we are well diversified. Hence, we just stay the course.

We spread our risk across a variety of holdings in the old time-honored method of portfolio construction that is as applicable to inflation-fighting strategies as it is to asset-growth strategies. Diversify; stick to value and quality. We also shift and rebalance to focus on companies directly affected like consumer staples, supplies, Industrials and maybe REITs.

Inflation and the Effect on Stock Prices

This is a very common question especially for those such as Millennials and Gen Z's that have not experienced inflation. For the most part it has been non-existent.

-Inflation in a rising economy has less impact -Known inflation can be embedded in stock prices -Sudden inflation reduces future earning projections -Consumers tend to save more when interest rates increase meaning, savings rates are higher. With increasing prices people have less disposable income. In time the economy will cool-down and inflation will decrease.

Let’s Do the Inflation Financial Tips Recap

#1 Inflation occurs when there is lack of materials and labor which increases prices and this is known as cost-push inflation.

#2 demand-pull inflation occurs when consumers are using more of a product or service. Hence, there is a surge in demand for goods across an economy which increases prices. #3 Inflation can have a sweet spot. From CNBC, when examining S&P 500 returns by decade and adjusting for inflation, the results show the highest real returns occur when inflation is 2% to 3%. This is where the current level is. (5/16/2021). This can be beneficial for stocks that pay high dividends are those that stand to gain the most from a strengthening economy. #4 When investing, it is always important to have a balanced portfolio so that you do not get overweight in one sector. This doesn’t mean that you can’t have more money dedicated to one or two industries/sectors and that you can’t adjust allocation from time-to-time; however, over time things typically balance out. So make the decisions based on your comfort level.

#5 When it comes to the budget it is important to make adjustments in your spending if needed. In addition, If you are contemplating a large, long-term purchase such as a house or car, make this factored into the spending plan especially in an increased inflationary environment. #6 Keep in mind, if you buy a house, a car, stocks or bitcoin and the value goes down, it takes twice as much as the loss incurred to break even on the original purchase. For example, if you own Apple at $100 and it goes down $50. That is a 50% loss; however, you need 100% gain to reach the $100 mark again.

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Episode Link:

What causes inflation and how to invest your money