What is inflation anyway?

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DutchGirl
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Post by DutchGirl »

Inspired by a recent post on calculating your withdrawal from your portfolio after retirement, and by a reddit post by someone who was mourning the fact that he had put money in a lower-yield savings account for a few years before buying a house (a house that had in the meantime decreased greatly in value) this musing:
How much inflation should I calculate with? The government (the US government, the Dutch goverment, the South African government) calculates annual inflation by seeing how much an average basket of goods costs for an average (?) citizen.
Now I'm pretty sure that I need to take into account some inflation, since over ten or twenty years prices of things increase with a significant amount, and I'm pretty sure my current budget of say 400 euros per month for groceries would become too little 30 years from now; even when I would economize and go to the cheapest shops instead. You can take a 1% or 2% hit on your grocery budget easily, but when prices have gone up by 20 or 30% after 10 or 15 years or so, things start to become different.
However, I'm not buying that many things. And some things, like computers and entertainment, have only become cheaper, not more expensive. The library helps too, and even while membership fees have increased by 10% this year, it's still only 5 euros per month for a luxuruous membership. Maybe I accidentily have the right kind of hobbies?
Do you calculate a personal inflation rate? If you're retired, have you increased your annual withdrawal with 1.2%, 2.4% or whatever your local official inflation rate was?


jacob
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Post by jacob »

YMOYL makes a significant issue out of that (dedicates a chapter to the point as far as I remember) essentially saying that inflation is not such a big deal when you're not consuming much.


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Sclass
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Post by Sclass »

@jacob good point. My neighborhood in Silicon Valley has two types of folks. Old people who live in $2M homes who cannot afford to paint them or trim their trees. Young industry middle managers who have jumbo incomes and jumbo loans complaining they can barely make ends meet. They pay 10x the property tax of the old people.
While the old guys are obviously avoiding the high costs that have outrun their incomes, it looks precarious for them. They are terrified by rising healthcare (inflation?) costs and bond measures on our property taxes that try to skirt the old prop 13 tax code (you pay % based on what your house originally cost). I envy them, but at the same time it looks hard trying to dodge rising costs. Not a place I'd like to be later on. I'd ideally want both low costs and high income ;).
I think Bernanke said something like this when the Euro was rallying against the dollar. Basically don't worry if you don't require imported stuff like parts for your BMW.
@Dutch_Girl I'm looking forward to hearing the members' explanations of "so what is inflation anyway?"
I've worked and saved during a time when inflation was at an all time low. The cost of gasoline has tripled since I learned how to drive thirty years ago...that's about 3-4%. Funny how even a tiny rate sneaks up on you. Electronics is cheaper. Jeans cost me half as much as they did in 1985. Houses on the street I grew up on (Los Angeles) have gone up 20x...about 7-8%. Residents correct me that's "asset appreciation" but it sure feels like inflation on my pocketbook. During the dot com bubble in Palo Alto it sure felt like inflation when a bunch of people bid up rentals, parking spaces, tequila shots, Audi A4s, homes etc. to higher values. But I was told that wasn't inflation either because it didn't involve money printing...those printed pets.com stock certificates sure looked like money at the time tho.
Obviously I don't understand inflation. Looking forward to enlightenment.
Wait...let me add to the confusion. How can prices go up when they are paying young employees less?


KevinW
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Post by KevinW »

There are two different phenomena that are both called "inflation" in common parlance. First, there is devaluation of currency that results from central banks creating money faster than the growth in demand for money. E.g. if in 1900 the US demands 100 units of money and there are $100 in circulation (1:1 ratio), and in 2000 the US demands 200 units of money and there are $400 in circulation (1:2 ratio), then the value of $1 is half what it used to be, aka 100% inflation. For various reasons central banks prefer a steady positive rate of inflation, say 3%-ish. In general* this only affects the value of $1 as a unit of measure (same for other fiat currencies) and has a proportional effect on all things priced in dollars. So it doesn't really have an effect on buying power, just the superficiality of price numbers getting larger.
* Setting aside for now taxes, imports, exports, the special case of monetary metal, and hyperinflation.
Second, over time macroeconomic trends changes the relative value of goods and services. For example in the 18th century the US was mostly frontier and the workforce mostly uneducated immigrants. So land and labor were very cheap; but professional services, manufactured goods, communications and freight were relatively expensive. In the modern US arable land and servants are a lot more expensive than they used to be, but shipping, communications, and access to professional knowledge are much cheaper. Back then middle class households could have servants and only the wealthiest could travel to other continents; now the situation has reversed.
I think the point made in YMOYL, and Jacob in the other thread, is that a good investing system will address the first problem, and being flexible and going with the flow can solve the second problem. In the 20th century the aristocrats that clung to the tenant-farmer model withered away, but the ones that transitioned with the 20th century model (e.g. Royal Dutch Shell) did OK.


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Sclass
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Post by Sclass »

@kevin thank you for the two mechanisms. They are quite different things, right?
What caused the inflation in pre-Hitler Germany? Certainly toward the end of their crisis they were printing a lot of money. But did that precipitate the problem? Seems some of the second concept was going on with their foreign exchange. It sounds like it was a complete loss of confidence in the currency happened.


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Dream of Freedom
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Post by Dream of Freedom »

"and I'm pretty sure my current budget of say 400 euros per month for groceries would become too little 30 years from now; even when I would economize and go to the cheapest shops instead."
Doesn't it depend what you invest in? Commodities go up with inflation, so does real-estate. Companies can usually pass their costs on to costumers. If you had enough money in food companies when your food prices went up you might be helped.
Is there even going to be inflation in the next decade or two? I mean the money supply from the government may be growing, but the money supply from banks is shrinking as people deleverage.
Is your example of how you would respond adaptive enough? You could say, grow a garden, or invite a few pigeons in for dinner maybe. Just (half) kidding. http://en.wikipedia.org/wiki/Squab_%28food%29


chenda
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Post by chenda »

@ sclass - I think fundamentally it was the costs of the great war, loss of sovereign territory (including industrial regions) collapse of production, political instability and punitive reparations imposed on Germany (which had to be paid for in gold and commodities if I remember correctly )
Incidentally it wasn't the hyperinflation of the early 1920s which led to the rise of nazism, but the mass unemployment and depression of the early 1930s. In fact the hyperinflation was fixed relatively easily, in part through the creation of a new currency.


KevinW
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Post by KevinW »

@Sclass

I'm not an expert on post-WWI Germany, my knowledge is limited to what I learned in high school, but my understanding is the same as chenda's. In the final stages of WWI, much of Germany's productive capital (factories, etc.) were destroyed and much of its workforce (adult males) were killed. On top of that the country was forced by the Allies to pay burdensome reparations. The economy went into a downward spiral which played out as a hyperinflation. That's an extreme case of my first kind of "inflation" where the worth of one German Mark went into downward spiral approaching zero.
That's very different from something like the rising price of Stradivarius violins, which makes sense given fixed supply and increasing demand. Or the falling price of recordings of Stradivarius violins, which has decreasing demand and increasing (practically limitless) supply.


jacob
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Post by jacob »

I don't have much to add to what KevinW said except that the one kind can be seen as monetary inflation (increase of money supply relative to goods) and the other one as economic inflation (increase of one kind of goods relative to another).
There's a third kind which could be termed financial inflation which works on expectation. In particular money is a claim on FUTURE goods. In that regard one would have inflation (of prices) if the purchasing power is expected to go down, e.g. because people expect their money to be worth less in the future (due to increasing taxes or higher interest rates).
Keep in mind that there's effectively no such thing as "absolute value". All values are relative to other values. The price is where aggregate demand meats aggregate supply. It's just so that all prices are denominated in dollars which makes dollars feel like they are more special than they actually are.
Exercise for the student: Imagine that from tomorrow on, all prices would not be denominated in dollars but in corn. How wealthy do you think you'd be then relative to now? (How much corn do you currently hold? How easily can you trade your stuff for corn?)


Dragline
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Post by Dragline »

Read "When Money Dies" if you want to understand the hyperinflation in Weimar Republic Germany. I found this documentary to be quite interesting, too: http://www.youtube.com/watch?v=DcPx2q2ZE30
As to the original question, what matters is the inflation rate in the currency that you live with. And if you don't have confidence in that currency, best to have some investments denominated in other currencies and/or some gold.


buzz
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Post by buzz »

With the corn analogy, I suppose the person who would do best in that scenario owns a lot of stuff that is highly valued and highly demanded by people who have corn. This seems to be in line with those who horde guns, rice, or gold instead of stocks/cash.
Or did this go over my head? (I never have understood inflation, I just know that it happens)


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