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By Pehon | July 17, 2007
Inflation and interest rates. The 2 seem to have been plaguing the US market over the last few months. And its having an effect on the world.
In fact, since 1948, the US economy has been looking at inflations for every single year, except for 2 years (1949 & 1955) (source miseryindex.us)
So what really is inflation and how does it affect your investment and money supply? And how does raising interest rate actually fix inflation problems?
In basic terms, if you are seeing an inflation of 5% this year, your $5.00 meal at the fast food would in theory be $5.25 the next. The main cause of inflation is the relationship between money supply and ability for the economy to supply (goods, or things for you to buy).
“Inflation explains why things get more expensive over time. Remember when chicken rice was only $2, or even less…….”
Its basically competition of supply for the limited supply of money. If there were an increase in amount supply, while there is a drop in money supply, we would see the economy deflate. However in today’s context, it will never happen. We are seeing increasing money supply while the supply isn’t increasing as fast, hence inflation is experienced.
So how does this affect your wealth? If you were to keep your money under your bed, your returns are basically 0%. And if the economy inflated 5% this year, your purchasing power has reduced by 5%, meaning you’re 5% poorer. The same way, if your bank pays you 3% interest in your fixed deposit account, while inflation stood at 5%, instead of being 3% richer, you’re actually 2% poorer. Hence its very important for your “cash” to grow at a faster rate than the prevailing inflation rate.
“Inflation makes you poorer, if you do not outsmart it”
So how do governments handle inflation? The best thing they can do is to raise interest rates. Increasing interest rates would encourage a shift in the people from having money in the economy, to saving the money in saving accounts in banks. This in turn will remove large amount of money from the market, hence reducing inflation.
“Raising interest rates removes money from the market.”
In addition to reducing inflation, the loss of money from the economy will also reduce the amount of money in the equity market. And hence, a raise in interest rate is dreaded in the interest of stock traders.
Inflation makes people poorer. In the long run, inflation is generally believed to be a monetary phenomenon, and hence its almost impossible to be avoided. However, its believed that a small annual inflation rate is healthier than a deflating economy. One of the effect of an inflating economy is rising wages, and hence prefered over deflation. The only thing we can do is to invest to match, or even out run inflation rates to preserve wealth.
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