Here are ten fundamental insights about inflation, how they will impact you – and how to change your thinking and behavior to best adapt to inflationary times.
1. Inflation is a tax on cash.
With 10% inflation, the $100 bill in your pocket is only worth approximately $90 next year.
If you keep your money in a savings account with zero or close to zero interest, the same is true.
You are paying a 10% tax on your nominal cash balance.
2. Inflation is also a tax on nominal contracts.
If somebody has promised to pay you $100 twelve months from now, and inflation is 10%, that contract is only worth $90 today.
What is a good example of this? Most employment contracts!
Inflation is a tax on wages and all other contracts denominated in fixed terms.
3. The impact of inflation compounds.
With inflation at 10% for 2 years, the price of things will not go up by 20%, it will go up by 21%.
After three years, it will go up by 33%, not 30%.
The impact of inflation compounds over time. Think of it as interest, but in reverse!
4. Whether you win or lose with inflation, depends on how you position yourself.
As a business, if you can keep your costs nominally flat, but pass on inflation in your price you can win.
If inflation increases your costs, but not your revenue, you will lose.
In other words, to understand the impact of inflation on your life or your business, ask yourself the following:
Is inflation increasing my costs? Is inflation increasing my income?
Depending on the answer, the impact can be good, neutral, bad, or ugly. Ideally you want to be in a situation where you can keep your costs constant, but increase your income due to inflation. If you find yourself in the reverse situation – increasing costs due to inflation, with no increase in your income – be careful! And take action.
5. In macro terms, inflation equals uncertainty.
If inflation is 1%, and goes up by half, it becomes 1.5%
If inflation is 10%, and goes up by half, it becomes 15%
Higher inflation thus increases uncertainty and volatility. Both are bad for markets, the economy and risk premiums. High inflation creates more volatility and risk in markets.
6. Emerging economies have to think harder about safe assets
If you live in a country that suffers from high inflation, the the U.S. Dollar or the Euro was “the” safe asset.
There is now a bigger inflation tax on those currencies. That means that a person living in Argentina may put their savings into dollars to protect against the peso losing value, but the dollar itself is losing 10% per year to inflation!
As a result, crypto, gold and other non-inflationary (or even deflationary) assets may start becoming more attractive.
7. We need to start thinking of “Real vs. Nominal” price changes.
With inflation at 1%, this difference was largely academic.
However, at 10%, the difference really matters.
For example: If your nominal house price stays flat, it is actually decreasing rapidly in real terms!
Similarly, with 10% inflation, if your house price goes up by 10%, in real terms it has only stayed flat.
And if your nominal house price goes down by 10% it has actually decreased by almost twice as much in real terms!
We have to get used to start thinking of real vs. nominal!
8. Real vs. Nominal interest rates really start to matter, and are driven by different economic factors.
In simple terms, Real Rates = Nominal Rates – Inflation
If your nominal mortgage rate is 6%, and inflation is 10%, your real rate is negative 4%.
If inflation drops to 4%, your real rate becomes 2%.
Thinking of real vs. nominal rates can be confusing, but it has very important implications for the economy.
Let’s illustrate this with a simple framework where real rates and inflation are either “low” or “high”.
There are four possible outcomes in this framework. i.) Real rates and inflation both being low, ii.) real rates and inflation both being high, iii.) real rates being low with inflation being high, and iv.) real rates being high with inflation being low.
In much of the 2010s, we lived in an environment where both real rates and inflation were low.
This was very good for asset prices. Nominal AND real house prices increased a lot.
The opposite of the 2010s would be an environment with high inflation and high real rates. E.g. 10% inflation, and 5% real rates would imply nominal rates around 15%. This clearly would not be good for asset prices or house prices.
But this is not where we are today.
Today inflation is close to 10%, w/ mortgages around 6%. High inflation, and very low real rates. This brings us to our next implication. What can we expect will happen to house prices today?
9. With real rates negative or very low, it is hard for nominal house prices to come down in the medium term.
It is likely that nominal & real house prices will diverge. Nominal prices may go up, real prices down.
A severe recession could always dent nominal house prices in the near term. But if this environment persists (very low real rates, high inflation), nominal prices will go up eventually.
What would happen to real prices is more difficult to predict and could be the subject of another blog.
10. Real vs. Nominal rates are driven by different economic forces and are hard to predict.
Inflation is driven by monetary policy. In other words, the more money we print, the more inflation we get.
Real rates are ultimately driven by the supply and demand for capital.
Forecasting how real and nominal rates will move, or what will happen to inflation is extremely difficult.
In summary, embrace the fact that we are now living in more volatile times. Adapt the right analytic framework, and design for flexibility in your life & business. Avoid nominal contracts unless it is your cost base. Pass inflation into your income stream whenever you can. And start getting used to thinking in real vs. nominal terms!