As governments and central banks around the world struggle to curb high inflation, it is worth understanding its major causes and how exactly inflation affects the value of money.
With inflation reaching record levels, money concerns are affecting ever broader swathes of society. Continuous price increases across most industries have forced the average household to reassess spending habits as essential costs swallow a greater chunk of the budget.
What are the major causes of inflation?
Most people pinpoint the global pandemic as the root cause of fast-rising consumer prices. After the restrictions from the Covid-19 lockdowns were eased, supply struggled to keep up with the surge in demand. Then, the already inflationary environment was further exacerbated by escalating geopolitical conflict and the energy crisis.
But how exactly does inflation happen? Here are the five main causes:
Demand-pull inflation
Demand-pull inflation is a sign of a well-functioning economy when incomes are growing and the unemployment rate is low. As people feel more confident with their money, they’re also willing to spend and consume more as their wages rise, which, in turn, decreases the supply of existing goods and services available on the market.
A strengthening economy results in too much money chasing too few goods. With enough money to purchase and not enough goods to meet people’s demands, prices rise and products become more expensive, thus leading to rising inflation.
Cost-push inflation
Cost-push inflation happens when the cost of production increases, literally pushing the prices of goods and services up. As wages rise and the cost of raw materials goes up, companies often choose to pass the increase in production and labour costs onto customers – driving up the price of their products or services.
This way, businesses can keep up with the changing market and maintain their original profit margin while producing the same amount of goods.
An unstable economic environment and unforeseen obstacles, such as a global pandemic, geopolitical conflicts, shortages or natural disasters often trigger cost-push inflation to arise.
However, the instigating factor does not necessarily need to be this drastic: such a scenario might occur simply because of the scarcity of materials, labour, higher energy and shipping costs, or simply a tax increase.
Increased money supply (i.e. money printing)
Increased money supply means the total amount of money in circulation outpaces the rate of production, causing too many dollars (or any other currency) to chase too few products.
In other words, people have to spend a greater amount of money for the same amount of goods, while the market supply remains the same or lower.
This inflated money supply leads to a decrease in the value of that currency as its purchasing power diminishes. In the worst-case scenario, it can lead to hyperinflation, as seen in the recent past in Zimbabwe for example.
Currency devaluation
Currency devaluation is the decline of the value of a currency in comparison to other global currencies. A favourable exchange rate incentivizes other nations to export their country’s products, making it more profitable to buy abroad than to produce locally.
Increased export competition reduces the incentive for local firms to cut manufacturing costs as materials are obtained cheaply. Simultaneously, it increases the risk for local businesses that cannot offer the same product at the same price as a country with a lower currency exchange rate.
At the same time, this strategy negatively impacts the import market, making it more expensive for the local citizens of the country with a weaker currency to purchase foreign goods.
Interestingly, currency can be deliberately depreciated to stimulate export activity by artificially lowering the prices of goods, which often goes hand in hand with keeping the national wages at a low level. This manipulation tactic can spread from one country to another as a result of a competitive trading environment.
However, other economic factors, such as political instability, different interest rates between two countries and an increased money supply can significantly contribute to currency depreciation.
Government policies and regulations
Although governments actively work to keep inflation at around 2%, their success rate depends on the level of political stability and administrative efficiency of the local authorities. Often enough, new taxes or government regulations provoke either demand-pull or cost-push inflation.
Whether by issuing tax subsidies to increase demand (which in turn potentially increases product costs) or by passing a portion of rent or fuel costs onto citizens as a part of price control and stabilisation policies.
Investing During Inflation
The first protection against high inflation is to have a sufficiently balanced portfolio that is able to withstand not just rising consumer prices but other factors that may arise, such as recession, housing market crashes and stock market jitters.
As such, it is unwise to make an investment solely on the basis of it performing well during periods of high inflation. That said, the asset classes likeliest to perform best are those with the scope to pass on these extra costs to their consumers or those with a finite supply, such as gold and commodities, which a central bank can’t simply print more of.
Quality companies and brands that consumers are established with – such as Adidas, food behemoth Nestle or drinks giant Diageo – are among those worth considering as customers are likely to stay loyal even if the goods go up in price.
Similar sectors, such as commercial property, with a prevalence of inflation-linked contracts, will be able to weather the inflationary storm. However, in the current environment where working from home has reduced the attraction of office space, this sector should be treated with caution with a focus instead on warehouse and non-office commercial options.
Kinesis Money offers two inflation-busting products in its digital currencies, KAU and KAG. These two products are backed by physical gold and silver respectively and enable holders to benefit from the metals’ ability to hold their value while also delivering a yield.
Holders of KAU and KAG can use the Kinesis Virtual Card to spend their gold and silver-backed currencies on everyday items. Users also receive a monthly yield based on the number of transactions carried out using these digital currencies.
Not only do the two currencies benefit from any gains in the gold and silver price, the monthly return also helps to ensure holders have extra cash to cover the rising cost of goods – making KAU and KAG a viable option to help combat inflation.
This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not commodity trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis.
