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Inflation
What is it and why is it important
Inflation. It's causing panic across all the major markets, including cryptocurrencies. Why is this? Why is it important and what does it have to do with digital currencies? We'll answer these questions today.
Inflation is the term we use to describe the increase in prices over time. How quickly those prices go up is called the rate of inflation. - The Bank of England
- In the UK, we know the rate of inflation because every month the Office for National Statistics checks the prices of a whole range of items in a ‘basket’ of goods and services.
- The price of that basket tells us the overall price level. This is known as the Consumer Prices Index or CPI.
- We can compare the CPI year on year to give us a level of inflation
The current level of inflation is (May 2022) year over year is 9.0%
That means that the purchasing power, which is the amount of goods that you are able to buy with a given amount of cash, is reduced by 9% each year. That means that spending £100 in May 2023 next will get you 9% less stuff. It also means that your stocks, shares and investments are worth 9% less.
The law of supply and demand is an economic theory that explains how supply and demand are related to each other and how that relationship affects the price of goods and services. It's a fundamental economic principle that when demand exceeds supply for a good or service, prices rise.
There are a few issues that hit all at once, and it's all about supply and demand...
- 1.Supply chain issues - Supply-chain disruptions have also persisted across the global economy, with Russia’s invasion of Ukraine and the recent rise of Covid-19 cases in China adding pressure. Energy prices, including gasoline, have gone up. Truck drivers, seaport slots and warehouse spaces are all in short supply, leading to costly delays and rising shipping rates for goods.
- 2.Surging demand - Consumers had lots of savings from the COVID period, Government COVID relief funds left people with more savings than usual to spend on goods and services. Companies can therefore get away with charging more, which causes prices to increase.
- 3.Production costs - The war in Russia has caused energy costs to sky rocket, which increased the cost of production.
The cost of living for the everyday person will increase each year because everything will cost more. This puts pressure on everyday people. The central banks understand that a small amount of inflation is optimal for the economy. It actually reduces unemployment and helps erode government debts. 2% is the target rate of inflation. To keep the economy at 2% inflation, central banks have tools that they can use. The primary tool is the interest rate.
Increasing the interest rate does a few things:
- Higher interest rates reduce demand - increasing the interest rate means it costs more to borrow money between banks, which is passed on to consumers and businesses as more expensive loans. This dampens demand and economic activity. It slows the economy because borrowing is expensive.
- Reduced demand lowers inflation - When it costs more to borrow, there is less demand for goods and services across the economy. This reduces the price of things (or at least reduces the rate of prices growing, they may not fall.) This is because price is a function of demand and supply. So if you reduce demand, you reduce price.
- Reduced demand also reduces growth - that is the cost here. The central banks are aiming to reduce prices by dampening growth. There is no alternative.
- Capital was free - now it is expensive. Think about how that affects households and business behaviour.
To tackle increases prices, central banks are intentionally reducing demand which also causes growth to fall - meaning that investments suffer. This is why markets react violently to interest rate changes.
The story of 3 charts...
Chart courtesy of https://ycharts.com/indicators/us_inflation_rate - this is the rate of inflation in the US
Inflation is on the move - so is the US FED and the UK BOE
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We see a sharp rise in interest rates in 2022 to combat that inflation
US stock market reacted by pulling back 20%
Inflation is stubborn, it reacts with a lag to policy changes, and if it spirals out of control , we have the dreaded hyperinflation.
The most famous cases of hyperinflation occurred in pre-WW2 Germany, when the weimar republic printed notes in order to pay off the heavy war reparations set upon them by the allies. What was the result of this? Prices ran rampant - a loaf of bread, which cost 250 marks in January 1923, had risen to 200,000 million marks in November 1923.
This was terrible for the majority of the population on fixed wages or with savings - although it did benefit those that were in debt and those within industries that had a fixed demand like farmers.
We see modern examples of hyperinflation in Zimbabwe and Venezuela. We see hyperinflation in play in the markets too.. the recent Luna crash was made exponentially worse through the forces of excess supply. Read more here.
Well as global markets move in lock step, we see more correlation between risk assets like US stocks and Bitcoin.
This means that as the stock markets tumble, so do cryptocurrencies. In the world of finance this is known as 'risk off' moves. Where investors and portfolio managers are selling riskier assets in favour of safer ones. Crypto is a 'risk-off' trade.
So, as a recap:
Inflation is caused by an imbalance of supply and demand caused by geopolitical issues-> an increase in prices forces central banks to take action to try and keep inflation at their 2% targets -> this dampens growth and as a result stock markets sell-off -> Stock markets are linked to cryptocurrency markets and therefore crypto sells off -> There is now a bear market
Anyone that tells you the answer to this with certainty is trying to sell you something. The truth is, no one really knows. The supply chain issues may free up and prices may come down, which would ease the pressure on interest rate rises and boost the economy- but they also might not. What is more important is to understand the mechanisms upon which it all works, so that you can make informed decisions as geopolitical and economic changes happen.
What do you want to learn about next?