Why inflation is still relevant today
In 1914 you could buy an American dollar for about 4.2 Deutsche marks. Nine years later and this had risen to an astronomical 4.2 trillion-to-one. Germany at the time was experiencing hyperinflation.
It was the 1920s and the government had commissioned 130 printing companies to churn out piles of worthless currency. The country had lost the Great War and it had to pay off huge debts and war reparations.
People collected their wages in wheelbarrows. Children played with wades of banknotes like building blocks. One distracted worker even found his suitcase stolen and his near-worthless cash left behind.
We’re a long way off from hyperinflation today. In fact few people, apart from our older generation, have experienced high inflation. That’s because inflation and real interest rates have been falling for a really long time – since the 1980s. Some people are even questioning whether inflation is even relevant today?
Let’s first look at why inflation is now so low.
Prior to the Great Financial Crisis, former Fed Governor Ben Bernanke made a very interesting remark. He noted that the global supply of savings had increased over the last 30 years, alongside falling inflation and real interest rates. Take a look at the chart below to see what he is talking about.
The reason these savings have been growing is because they haven’t been met by enough demand. Real interest rates have struggled to fall low enough to clear the glut. The more people save and the less they spend, the lower the level of inflation falls. Personal savings rates might have fallen, but they are still adding to the past weight of savings that are still sitting in the banks.
There are lots of reasons about why savings are increasing. The integration of China into our modern world economy has brought more than a billion people with a 40 per cent savings rate, creating a huge wall of new money. Deleveraging since the Great Financial Crisis has also continued: younger workers are saving more than ever to clear student loans and buy a home in an already expensive housing market.
The way interest rates have also traditionally functioned may have also changed. We have always assumed that low interest rates lead to greater consumption. Yet for those looking to retire, lower interest rates mean that they have to save longer and harder because the cost of an annuity is now higher. Furthermore, our ageing populations make this point all the more relevant. We’ve living longer and more healthy lifestyles.
So back to the question is inflation still relevant?
The problem is that inflation has risen dramatically in some areas and fallen substantially in other. Real estate and education for instance are now extremely expensive relative to history. However, technological improvements – storage costs, digitalisation and robot automation – have boosted productivity and continue to do so, improving efficiency and bringing down overall costs.
BlackRock’s CIO Rick Rider made a very interesting observation on this subject:
“An iPhone in 1991 storage and computing cost dollars would be worth $1.44 million per phone. An iPhone today costs a minuscule portion of that,” he said. “That gives you some sense for this incredible inflationary impact on so many things that are now done via mobile or done through automation”.
Here’s another interesting idea. Inflation is also less relevant today because we are becoming increasingly cashless. Venezuela for instance, is our current modern day example of a country suffering from hyperinflation. It’s probably the first to experience hyperinflation in the new digital age. Yet its population is coping far better than German citizens did in the 1920s. And there is a good reason why – mobile wallet providers!
Everyone in Venezuela is using them to transact, including vegetable sellers and taxi drivers. It would be impossible to tip a waiter or pay for parking without these mobile apps.
But that doesn’t mean that inflation is less relevant. It means it’s less burdensome than before because you no longer need a wheelbarrow to carry your cash. You still need to spend your money as soon as you earn it, before it become worthless however.
But in an era where unregulated crypto-currencies now exist, there will be plenty of substitutes in the future for citizens of any country if their official currency is destroyed by hyperinflation.
Inflation is starting to become a hot topic once again. Last week US inflation data delivered a surprise amidst the market volatility. The US CPI was up 2.1 per cent, which was above predictions. Commentators are now talking about rising inflation, which is a subject that hasn’t been spoken about for a very long time.
Of course inflation, alongside expectations for inflation, still remain historically low. However, even benign levels of inflation can still erode the value of money substantially over time.
For the last one hundred years, inflation has been around 5 per cent, which is pretty low. Yet if you compound this rate over this period, then that’s enough to destroy 90 per cent of the purchasing power of the cash you hold.
That means that inflation is still the enemy of your long-term wealth.
That is why it in so important to invest.
