Governments around the globe have taken a no-holds-barred approach to fiscal stimulus. And with President Joe Biden's plan to pump a further $1.9 trillion into the economy, the financial world remains divided about the potential for inflation.
But what is inflation exactly, and how could its effects ripple throughout the economy?
Most people have stories about grandparents who plunked down 5k for a three-bedroom house in the 1950s. Obviously, such a thing would be impossible today because of inflation. Inflation is simply the rate at which a currency loses value.
There are three basic types of inflation, according to economist Robert J Gordon. They are demand-pull inflation, cost-push inflation, and built-in inflation. When wages rise, or the economy expands, consumers tend to have more money. But often, suppliers tend to have few goods for consumers to purchase with their newfound cash-this pattern of low supply and high demand results in demand-pull inflation.
Cost-push inflation occurs when the cost of production rises. For example, if oil prices spike, the cost of manufacturing goes up, and retailers then push these increased costs onto consumers. Built-in inflation results as the other two types of inflation occur over time. As the cost of living creeps up, employees demand higher wages, and built-in inflation occurs.
If inflation occurs too rapidly, a currency can dramatically drop in value. Consumers then realize that their cash will be worth less over time, which causes them to buy more and more. The more cash in circulation, the more a currency drops in value, which creates a vicious feedback loop that can decimate an economy. Such was the case in Weimar Germany, where in 1923, a single U.S. dollar was worth roughly 4 trillion German marks. Essentially the currency became so worthless people began to use it as wallpaper.
The Weimar example illustrates how crucial it is for central banks to control the amount of money in circulation. Usually, agencies like the Federal Reserve control the money supply by controlling interest rates. High-interest rates result in fewer loans, and therefore less money in circulation. On the other hand, low-interest rates result in more loans, which increases the money supply.
Since 2008, economists have argued about the dangers of near-zero interest rates as it relates to inflation. These low interest rates have persisted for more than a decade. And now with the federal government poised to inject even more cash directly into consumer's savings accounts, the dangers of inflation seem more acute than ever.
You can protect yourself against inflation by investing in assets that won't lose value due to inflation. Real estate, precious metals, and commodities tend to hold their value even if when takes more cash to buy them. Fixed-income assets like Treasury Inflation Protected Securities (TIPS) increase in value in line with inflation.
While Weimar style inflation is unlikely, it can't hurt to protect yourself by adding tangible assets or Inflation Protected Securities to your portfolio.