Inflation is an easily understood phenomenon. Although it takes a myriad of think tanks to find the root of the problem, the issue is quite simple, and investors can easily prepare their portfolios against the ravages of inflation.
The Source of Inflation
Inflation can occur for a variety of reasons. One of the most common is the issuance of new currency by the central bank and the reduction in interest rates. Another source is government debt issuance, whereby one nation borrows money from another and increases the amount of money in circulation within the borders of the borrowing country.
The last source of inflation, and undoubtedly the weakest, is the velocity of money. When money is moving faster through the economy, prices are quicker to inflate, although the supply remains the same. The velocity of money is usually only temporary, such as the increase in prices in a specific city during the Olympic Games.
The Route of Inflation
Inflation’s road map is generally very simple. Due to the processes that create inflation, it typically affects certain markets before others. One of the first markets to experience inflationary conditions is the commodities and metals markets. When central banks lower the interest rate, investment banks and other investors find it less expensive to leverage upwards, and thus, they make larger bets in the capital markets. In addition, the capital markets come with few restrictions and excellent liquidity, providing an opportunity to move new money in and out of the market relatively quickly.
The next sector that is prone to inflation is the real estate market. Although real estate is typically considered illiquid, it is full of investors and ordinary homeowners who use low rates created by a central bank to buy housing inexpensively.
The final destination for inflation is consumer prices at retail outlets, stores and restaurants, as the higher prices in raw goods on the commodities market make their way down the supply chain to the end consumer.
The Cost of Inflation
Inflation has dramatic impacts on the business cycle and even larger impacts on the raw spending power of consumers. A stable currency and exchange rate are one of the keys to a solid and productive economy.
Prior to the creation of the US central bank, the US economy experienced one of the greatest growths in productivity during the Industrial Revolution. A stable currency allowed for companies to make long term contracts, and the capital required to make large investments was available without large fluctuations in the price of the currency.
Today, however, volatility in the value of the currency prohibits companies from making long term contracts and guaranteeing prices, which has further eroded the spending power of consumers.
Investing in Inflation
Inflation is a market problem that only affects those who are not properly hedged against the risk of growth in the money supply. Although precious metals are often regarded as a hedge, they typically perform better than the rate of inflation and the increase in the money supply.
For example, the US dollar has depreciated by only 8% in 2009, yet silver’s price has grown more than 57%. Although prices may have increased in US dollars, they’re down considerably from the start of 2009 when priced in silver.
It has never made more sense to own silver coins – not only protect yourself from the threat of inflation, but also to grow your spending power as the US dollar deteriorates.
Many people new to precious metals find it difficult navigating the waters of the non-main stream. Small steps are a great way of getting started.