Remember the toilet paper crisis in April 2020? Not only was toilet paper hard to find, but even if you did find a few rolls, the price probably had quadrupled. While busy contemplating how to do our daily business without toilet paper, the entire nation also felt bewildered. How could this have happened?
Fast forward to today. We are happy that the toilet paper crisis passed, but the bewilderment and discontent has persisted—this time not regarding any specific item, but rather the widespread increase in prices, which we call inflation. Almost everything has become more expensive, and by a lot. A Big Mac hamburger that cost $4.71 before the pandemic now goes for $5.69—a 21% increase in price. Coincidently, the overall inflation, as measured by the Consumer Price Index (CPI), also increased by 21% during the same period.
Daniel Chi
If we take a longer-term view, over the past 100 years, CPI has increased by 1,727%; or the purchasing power of money has decreased by 95%. That is, what cost $1 in 1924 now costs $17.27; and $1 then is worth only five cents now. The inflation monster eats away your money.
What causes inflation? One cause is the imbalance between supply and demand. Taking the toilet paper crisis as an example, in aggregate we did not start using more toilet paper in April 2020, but because we started working from home, the demand for at-home toilet paper (as opposed to the office kind) did increase, and it took time for the manufacturers to adjust their production to meet the altered demand. Eventually, supply was adjusted to meet the demand, and the price settled down.
But what about everything else? We are not eating more Big Macs or using more of other stuff. How come their prices have also increased? The second cause of inflation is increased money supply that outpaces the underlying economic growth. Consider this fantastic proposal: If I were elected president of the United States, I would double everyone’s wage so that you will all be twice as rich. (By the way, I am not running, but if this sound good to you, you can write my name on the ballot.)
Will you be twice as rich? You will make twice as much money, but what will happen to the price of everything? The price of everything will probably double. When the money supply outpaces the underlying economic growth, prices go up—that is, inflation occurs. At the onset of the pandemic, the government implemented enormous fiscal and monetary policies to prevent the collapse of the economy and to supplement lost income for a large proportion of the population—all well-intentioned moves that mostly achieved their intended goals. But the unintended consequence has been runaway inflation. Inflation has been coming down and the trend is promising, but the scar will be noticeable for quite a while.
So what shall you do to protect your money from the inflation monster? First, understand the detrimental effect of inflation on your wealth. For the past 100 years, the average annual inflation was a modest 2.9%. But even this modest inflation has eaten away 95% of money’s purchasing power. So, first be mindful that if your savings are not generating a return high enough to offset inflation, you are losing money.
Second, once you understand the effect of inflation, find a savings or money market account that offers you a higher rate. Nowadays you can easily open an online savings or money market account at no cost. Currently a money market account should give you an annual return around 5%.
Third, if you want to protect your wealth from inflation in the long run, you have to move out of cash and invest in long-term assets, such as bonds and stocks. Bonds will generally protect you from expected inflation. But when inflation spikes unexpectedly, such as in the past few years, bonds get crushed, and the main reason is that the coupons of most bonds are fixed, hence the name “fixed income”—that is, the coupons are not adjusted to compensate you for unexpected inflation.
For the long run, stocks provide much better protection against inflation because stocks represent ownership in businesses. What did businesses do in the past few years? They raised the prices of their products. As a stockholder, and hence an owner of a business, the return on that stock will increase with inflation, and hence provide inflation protection for your wealth.
But again, as I’ve written before, unless you are well trained for investments, do not try to pick individual stocks. Rather, invest in a well-diversified stock index fund. In the long run, you will actually outperform most of the investment professionals.
The inflation monster is voracious, but you can protect your money (and your Big Mac) from it.
Daniel Chi is professor and chair in the Department of Finance at UNLV’s Lee Business School.
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