Inflation – why do prices increase? by Rico Dilello

By Rico Dilello

My last blog post “Back to the Future: Investing in 1985 verses 2015” contained some consumer items priced in 1985 dollars. A blogger friend of mine posted a comment asking some interesting questions regarding inflation. Understanding inflation is really important to your financial well-being. So, why is cost of a house, car or food more expensive today than 30 years ago?

According to my economics professor there are two types of inflation:

Demand-Pull Inflation – is simply too much demand and not enough supply of a product or service. A good example would be Disney raised its prices for a yearly pass at its California theme park from $700 to $1,000 because of overcrowding. Other factors that could sometimes increase demand is government spending. China drove commodity prices higher with massive spending on infrastructure. Some economist believe that money printing by central banks or tax cuts could cause inflation “too much money chasing too few goods.”

Cost-Push Inflation – is when prices have been “pushed up” by increases in costs of producing a product or service. These costs include wages, land, materials, energy and capital. A good example was the 1979 oil shortage crises that resulted in a spike in energy costs. The Fed Chairman, Paul Volcker, had to raise interest rates to 20% to stop inflation. Other factors that could add to cost push inflation are taxation and regulations from different levels of government. Plus research & development costs associated with bring new products to market.

Now the world is far more complex than what is in the pages of my economic text-book. The “Great Recession” has thrown the world into a long deflationary cycle. Everyone loves a bargain. The problem is that wages have also dropped. Many high paying jobs have disappeared in construction, manufacturing, oil & gas and mining industries. They have been replaced by part-time work and lower paying jobs. Although the rate of inflation is lower, consumers have less disposable income to spend.

Most of the world’s central banks are now trying to inflate with low interest rates and reducing the value of their currencies. However, all this printing of money hasn’t convince consumers to open their pocketbooks and spend! Instead, these measures have inflated stock prices. (The rich are getter richer)

Here are some ways that this information may improve your financial well-being:

  1. The cost of a college education has a text-book demand-pull inflation factor. If you have an education savings plan, you may want to underweight bonds and overweight the stock portion of your portfolio.
  2. House buyers should look at neighbourhoods that are in high demand to ensure that their house will increase in price over time. (Toronto & Vancouver are examples of two Canadian cities where high demand has kept house prices rising)
  3. Readers of my blog know that I have recommend avoiding investing in oil & gas stocks as well as other commodities. Too much supply combine with weak demand have caused prices to fall resulting in lower corporate revenue and profits.
  4. Even today’s low inflation rates are eroding the purchasing power of your money sitting in saving accounts and in short-term bonds. The interest that you earned is below the rate of inflation. Investing in dividend paying ETFs or stocks maybe a better option.
  5. Inflation is good for borrowers who use the funds for items that increase in price. Not so good for items that are falling in price. Paying down debt is more important during deflationary times. (13% of U.S. homeowners are still underwater with their mortgages)
  6. Stock pickers should look at companies that have strong pricing power or the ability to lower costs of production. (Some consumer brands sell their products at higher prices than their competitors)

 

cautionThe government measures CPI based on the Average Price of a basket of consumer goods and services. Keep in mind that the cost of living in an urban center is much higher than rural areas and there are many everyday items that are not included in the CPI basket.

By Rico Dilello

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