Monday, July 25, 2016

Inflation - what is it?

Dear reader,

if you have a house, or you want to buy one, or you live under rent, I strongly encourage you to read what follows.
In a previous post, I wrote about the important sum of money I recently saved by NOT buying a house in the Netherlands in 2015. And I suggested you to wait until the first quarter of 2017 to do that.
In another post, I explained the subtle difference between money and credit: at present, we can conclude that under the current monetary system, money and credit are essentially the same thing.
And, since debt is the other side of credit, we have the following identity


The difference between money and credit is the following: money does not bring a yield, credit does. So, a bank deposit gives a yield, so the money in the deposit is, more correctly, credit. Cash does not bring interest, so it is money. 
Gold is the ultimate form of money, in that you keep it in the case of an economic collapse and as an asset to give to your offspring, which can be traded for whatever may be necessary in bad times. Bitcoin does not bring any yield, therefore it is money but currently suffers from many limitations (I explained these limitations here).

Nevertheless, nowadays commercial banks and central banks create money out of thin air: commercial banks create money when they create bank deposits, and further multiply this money by the mechanisms of fractional reserve. Central banks create money by increasing commercial banks' reserves. 
In the moment you withdraw cash from an ATM, that cash is decreased from the reserves of the Commercial Bank; the same figure is decreased from the balance sheet of the bank account under your name and therefore it ceases to be money for the bank to be used for its investment purposes or a debt towards you since the bank has to pay you a (very low) interest on your deposit. 
In other terms, in the form of cash, credit has turned into money. But cash is going to be banned, so only digital money, ie credit, is going to exist in the close future. 
I will cover this in future posts: now it is out of the scope of the topic I want to deal with. I realize that money creation and transformation is a complex matter and therefore I just wanted to give you a clue about the complexity of the topic. 

Due to the former identity, in this blog I mention indifferently about money or credit or debt. 
Today I want to talk about inflation. 

Some common definitions for inflation are the following.
  1. Inflation is a general raise in the cost of goods and services.
  2. Inflation is a general loss of value of your money.
  3. Inflation is the increase of money supply.

This is what you typically hear from TV news, talk-shows, etc. 
They are all correct, and highlight different aspects of inflation. 

For our purposes, inflation is what you observe when there is a general raise of the price of a few of , or all, these categories: homes, rents, energy, food, consumer goods, transportation costs, investment assets (like treasury bons), etc. 

The opposite of inflation is deflation. That is, your money increases in value. So, you can say that in deflationary periods, with the same money you can buy more stuff.
So, deflation is negative inflation.

Plain and simple, isn't it?

Well, actually it is not, at least for me. Just try to think about this for a moment: inflation is a human activity byproduct. I mean, the sun rising at East and setting at West is a plain and simple fact. Why does inflation exist? why sometimes they say we are in inflation and some other times they say we are in deflation? Who, or what, creates inflation? what does inflation affect? Is everybody affected the same way by inflation or deflation? Is it inflation bad and deflation good? Is deflation bad and inflation good? Can I make money in an inflationary period? or in a deflationary period?
As far as I know, we were not born with the letters of inflation forged inside our DNA.

Why am I so interested in inflation? You, as an informed family father, should be interested in inflation. Because, according to which side of the former identity you are (CREDIT or DEBT) you may lose wealth and your well-being or increase your wealth and your well-being.
Remember, if there is a creditor, there is a debtor, and vice versa. If there is an uphill, there is a downhill. You need to have the complete picture inside your mind to take effective decisions.

If you think deflation is good because with the same cash you can buy more gasoline, a better TV, a bigger house thanks to lower interest rates etc,, I remind you that on the other side of the coin  there must be somebody which is negatively affected by all this, namely the energy companies, which pay their employees, or the bank which has less marginal gain when they buy government bonds.
If you work for a bank which is currently suffering from low interest rates, you may be fired. Idem, if you work in the oil industry, and oil is paid very low, yes, you save money at the gas station, but you are fired because the oil company you work for is going bankrupt.
And if you are a retiree, with a fixed pension? well, in your case deflation is super welcomed. You get a pension, an income, which is raising in purchasing power for free! Unless the State, which gathers money through taxation and the issuing of new debt, go bankrupt because companies are selling stuff at a cheaper price, therefore their revenues decrease, their profits decrease and they pay less taxes to the government.

So, accordingly on what net position you have with respect to inflation/deflation, you may become richer or poorer, on the long run.
That is exactly why you need to understand how money is created and transferred. And how to hedge your assets, if you have any (and I include in your assets, forth and foremost, your children and your family).

Before moving on, I want to stress one point: we must be interested in the expected inflation, that is the future inflation rate, that is the inflation rate that is likely to occur in the forthcoming months. Remember what I told you about information: information is inversely proportional to the likelihood of a future event. If the event has happened, there is no precious information associated and you can throw the information about inflation in the "noise trashcan". Good for past statistics. Not for you.

I ran a poll among those friends and relatives of mine who claimed to know the meaning of inflation.
I asked them two questions:
1. if inflation is constant, is the price of things constant?
2. If inflation is decreasing, is the price of things decreasing?

The answers to both questions were all (well, all but one!) a sound "yes".

The correct answer is NO. Welcome to the realm of dis-information and mathematics.

I will explain this by an example.
Suppose you have 1000 euros, and the expected rate of inflation (or inflation, for the sake of brevity) for next year is 2%. This means that if today (2016) you can buy things that are worth 1000 euros, next year the same things will cost you 1020 euros, that is 2% more. Things cost more or, equivalently, your money is not worth the same.
Now the TV news say that in 2018, two years from now, the inflation rate is constant, ie still 2%. You may argue that the prices will be the same of 2017. Not at all! since inflation is a RATE, then prices are still rising, at a higher pace then before! in our example, from 2017 to 2018 prices are expected to raise by 2%, so our stuff that in 2017 is expected to cost 1020 euros, in 2018 it is expected to cost 1020*1.02= 1040.4

So, let's recap: the expected inflation is 2% for the incoming two years. It's constant. But the prices are raising. From 1000 euros in 2016, to 1020 euros in 2017, to 1040.4 euros in 2018.

Inflation for the cost of living is like the acceleration of a car for its speed: at low speed, if you keep the gas pedal fixed, ie the acceleration is constant, the speed, aka the cost of living, increases.

If deflation is decreasing, but it is still positive, you release a bit the gas pedal, so the velocity increases less than before but, in any case, it still increases.

NOTE: I know most of you do not love mathematics, but it is important to understand a thing. Inflation rate is called rate because it is essentially a ratio. In particular, expected inflation it is the ratio of the expected future cost of things, minus the present cost of things, divided by the present cost of things. In mathematical terms:

Expected rate of inflation = (estimated_future_cost_of_things - present_cost_of_things)/present_cost_of_things *100

Unless you love maths and crunch number, you can skip what follows and go straight to the conclusions of this post.

So, let's go deeper. If three people's height  are, let's say, 180 cm, 192 cm and 175 cm, what is the average height? well, you sum up 180 + 192 + 175, divide the result by three, and you get the average height.

Now, let's suppose that the rate of inflation for 2016 is estimated to be 3%, for 2017 is 6% and for 2018 is it is forecast as of 4%. What is the average rate of inflation?
Well, it seems easy: 6% + 3% + 4% = 13% divided by three years makes 4.33%.


Let's find out; well, let's say you buy something that costs you 100 dollars at the beginning of  2016.
At the end of 2016, it is gonna cost you 100*1,03=103
At the end of 2017, it will cost 103*1,06 = 109.18
At the end of 2018, it will cost you 109.18 * 1.04 = 113.55

So, in three years, the increase of cost will be

(113.55-100)/100 % = 13.55 %

For one year, on average, it will be:

13.55/3 = 4.52

So 4.52 is the real inflation rate year over year?


The average inflation rate is the fictitious and constant inflation rate that, over three years,would produce the same increase in prices of the three single and distinct rates.

Where is the issue? Again, inflation rate is...a rate, that is a ratio. And ratios are "averaged"not with a simple arithmetic mean, but with a geometric mean.

NOTE: the geometric mean in this case is (1.03 * 1,06 * 1,04)^(1/3) which gives 1.043259 ie an inflation rate of 4.32%. So the precise figure of the inflation rate turns out to be 4.32%.

Let's see if this is correct.

The original 100 euros, with an average inflation of 4.32%, computed with the geometric mean, shall become 100*1.0432*1.0432*1.0432 = 113.55. That's correct.

Hey Lorenzo -you might object - the average mean produced 4.33%, the difficult geometric mean gave 4.32%, so who cares? Let's use the arithmetic mean and that's it!
You are right: when the inflation figures are positive, strongly similar to each other, like in this case, and you consider only a few  years, there is not so much difference. Economists would say that the error is negligible.

We will incur again in the geometric mean when we will compute the yield of an investment. In that case, we will see that average and geometric means can be very different, and painful for your wallet if you do not take them into account.

Conclusion: in this first post on inflation, we have understood that inflation is a raise in the prices of things, from the vegetables to the houses to the treasury bonds to the cost of the bust tickets.
Inflation constant means price are raising, not that prices are constant.

So, just to make you "taste" inflation, let's suppose that for 5 years inflation rate is 5% year over year. And let's suppose that in the contract of your rent, it is clearly stated that the rent adjustment is based on inflation figures released by the statistics department of the government. It is not bizarre: my own rent contract in the Netherlands states that! So, let's suppose that today you pay 1000 euros per month for the rent.
How much will you pay five years from now?
1000 * (1 + 0.05)^5 = 1276 euros.
That is a whopping 276 euros more, or an increase of almost 30% of your rent.
So, 5% for 5 years is not 25% more, it is 27% more!

Now, as a family father, you understand that if you have an apartment to give for rent, it is good for you to write a contract in which the rent is linked to inflation, if you see that inflation is expected be positive for the forthcoming years. On the opposite, if you think there will be deflation, just go for a rent contract with fixed payments.

Coming back to my experience: in the house I have given for rent in Italy, I have chosen a fixed payment contract. There is almost deflation in Italy in the real estate sector. Here in the Netherlands, I have chosen an inflation linked rent. There is almost deflation also here, so I do not expect my payments to increase, at least until mid 2017.

We will come back to inflation again in the near future: sectors, causes, consequences, and forecasts for the real estate market and for government fiscal policy. We will also see that there is a good deflation and a bad deflation. And that the way inflation is created increases the gap between the poorer and the richer.

Inflation is the most important macroeconomic indicator that Central Banks use to steer their monetary policies. And the decisions taken by Central Banks have an indirect yet deep impact in our everyday life.

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