A Complete Guide to Understanding and Protecting Against Inflation

Learn about inflation, deflation and hyperinflation, and the best inflation hedges to protect your wealth.

What Is Inflation and How Is It Calculated?

Inflation measures the rise in prices over time. The more the overall prices for food, housing, clothes, healthcare, and other goods and services increase, the greater the rate of inflation.

This guide provides a detailed overview of what causes inflation, how it is calculated, and how central banks attempt to keep inflation low. The guide also explores deflation, hyperinflation, and what investments are best to protect against the ravages of rising prices.

Government statistical agencies, such as the U.S. Bureau of Labor Statistics (BLS), measure inflation by calculating how the prices of items that are included in a reference basket change from one period to the next.

For example, the BLS reference basket used to calculate the U.S. Consumer Price Index, a broad measure of U.S. inflation, has over 200 categories of goods and services purchased by households. These goods and services are divided into eight major groups:  food and beverages, housing, apparel, transportation, medical care, recreation, education, and communication.

Consumer Price Index Eight Major Groups

What Causes Inflation?

Inflation is the result of businesses charging more to their customers for goods and services. A business will often raise its prices if it finds the cost to produce an item or deliver a service is increasing. Businesses try to pass those higher costs to their customers in order to keep business profits from falling.

There is a chain reaction as businesses that sell to other businesses observe higher costs and raise their prices. This leads other businesses to charge more to households. Those household members then demand more compensation from their employers, which increases the businesses’ costs, leading to another round of price increases.

As households and businesses see prices increase, they may accelerate their purchases in order to front-run further price increases. That can lead to shortages or capacity constraints as businesses have difficulty keeping up with the demand. A constrained supply of goods and services in the face of increased demand leads to further price increases.

That then is the mechanics of rising prices, but what are the underlying forces that can set inflation in motion? The first force is an increase in the money supply.

The Money Supply and Inflation

Inflation occurs when the supply of money in an economy grows faster than the number of goods and services available for sale, resulting in price increases. Money is purchasing power. The more money households or businesses have in their checking accounts, the greater their purchasing power.

Businesses and households can increase their purchasing power by borrowing money. When a bank makes a new loan, a new digital bank deposit is created, which the borrower can spend. The more banks lend, the more money they create. In most countries, bank lending is the primary reason the money supply increases.

The money supply also increases when the federal government runs a large budget deficit and the central bank funds that deficit by purchasing government bonds as part of quantitative easing programs.

In the United States, in 2020, the budget deficit ballooned to $3 trillion, about 15% of GDP. GDP or gross domestic product is the monetary value of output produced, such as goods and services. The deficit increased due to falling tax revenues from the Covid-19 induced recession coupled with government stimulus and expanded unemployment benefits.

Meanwhile, the Federal Reserve, the U.S. central bank, bought $3 trillion of U.S. Treasury bonds. The combination of a government deficit and Federal Reserve bond purchases caused the M2 money supply to increase by 25% in 2020. M2 is an aggregate measure of money that consists of currency, checking accounts, savings accounts, and retail money market mutual funds.

As purchasing power and the money supply expand, there is greater demand for goods and services, as well as for the inputs used to produce those goods and services. If the supply of inputs and final products doesn’t increase as much as demand, that puts upward pressure on prices, leading to inflation.

Economists track the amount of money relative to the size of the economy. One measure is to divide M2 by GDP. Between 1980 and 2010 the amount of M2—currency, checking, savings, money market funds—as a percent of U.S. Gross Domestic Product, the monetary value of output in goods and services, was between 0.46% and 0.58%.

Since 2010, primarily due to government budget deficits combined with quantitative easing programs, the M2 money supply as a percent of GDP has increased. It was 0.7% at the end of 2019, and today it’s close to 0.9%.

If we take the inverse of the above equation and instead divide GDP by M2, we get what is known as the velocity of money. The Federal Reserve Bank of St. Louis describes the velocity of money as “the frequency at which one unit of currency is used to purchase domestically-produces goods and services within a given time period. In other words, it’s the number of times one dollar is spent to buy goods and services per unit of time”

If the money supply grows by more than the amount of output produced then the monetary velocity slows. There is less turnover as there are fewer transactions relative to the size of the economy. In the U.S., the velocity of money is 1.1., a historic low, and half the level it was in 2007.

Monetarism is an economic view that the primary inflationary force is an increasing money supply. Keynesians also believe the money supply influences inflation, but they also emphasize the role of borrowing, interest rates, central banks, and capacity constraints in contributing to inflation.

Summary of What Causes Inflation

• Banks create new money by lending to households and businesses.
• Federal government budget deficits combined with central bank bond purchases also creates new money
• Households and businesses spend the new money on goods and services, creating increased demand.
• If the supply of goods and services doesn’t increase as much as demand, that puts upward pressure on prices, leading to inflation.

How the Federal Reserve and Other Central Banks Use Monetary Policy to Control Inflation

Interest rates are another force that affects inflation. Central banks, such as the U.S. Federal Reserve, the Bank of England, and the Bank of Japan are responsible for making sure their country’s inflation rate stays low. Central banks seek to control inflation by influencing the interest rates banks charge on loans. When banks increase their loan rates, households and businesses take out fewer new loans. Fewer loans means less money is created. The money supply doesn’t expand as quickly, keeping inflation low.

Central banks influence lending rates by setting a policy target for very short-term interest rates. These short-term rates include the interest rate banks charge to lend to each other and to borrow money from the central bank.

In the U.S., the policy target is called the federal funds rate or fed funds rate for short. By raising or lowering their policy target, central banks set a floor or lower bound for interest rates.

Monetary policy consists of actions by central banks to control inflation by influencing interest rates.

The higher the central banks’ policy rate, the more banks need to charge on loans in order to make a profit. As banks raise the interest rates on loans, fewer consumers and households are willing to borrow. Fewer loans slows down the rate at which the money supply expands. Actions by central banks to control inflation by influencing interest rates is called monetary policy.

How Capacity Constraints Lead To Inflation

Central banks pay close attention to the capacity of the private sector to produce goods and services. If capacity appears constrained, such as factories are running full tilt, utilities are close to maxing out the power grid, and the unemployment rate is low then that can lead to rising prices.

When these capacity constraints occur at the same time banks are accelerating their money creation by lending, then inflation can rise faster than the central bank’s target inflation rate.

Skilled workers are critical to the private sector’s ability to produce goods and services. As more workers get hired and the unemployment rate declines,  employers struggle to fill jobs needed to expand the production of goods and services.

In a tight labor market, businesses compete for new workers and try to keep existing employees happy by paying them more. As wages increase, businesses will often raise the prices on their products and services in order to keep existing profitability levels, which leads to a higher inflation rate.

What Is NAIRU and the Neutral Rate of Interest?

Economists and central bankers believe if the unemployment rate falls too low that wages and inflation will rise too fast. The level of unemployment below which inflation could increase is called the non-accelerating inflation rate of unemployment or NAIRU for short.

No one knows exactly what that rate of unemployment is, but it appears to be around 4% to 5%  in the U.S. If the unemployment rate falls below the NAIRU rate, an additional unknown is whether inflation will spike or rise more gradually.

In theory, there is a level for short-term interest rates set by central banks that keeps inflation near the target inflation rate while maintaining full employment, a condition when anyone that wants a job can get a job.

The optimal level of rates is called the neutral interest rate. It represents the central bank policy rate at which unemployment is at or near the non-accelerating inflation rate (i.e., NAIRU) and prices are generally stable.

Former Federal Reserve Chair Janet Yellen used the story of “Goldilocks and the Three Bears” to illustrate the neutral federal funds rate, stating that “monetary policy should be at neutral only when economic conditions are ‘just right’.”

More often than not, countries do not have a “Goldilocks” economy. Either unemployment is too high or too low or inflation is too high or too low.

When the Federal Reserve and other central banks believe unemployment is too high and inflation too low, they lower their policy target for short-term interest rates to encourage more bank lending and money creation, which can stimulate the economy and increase inflation and employment.

If unemployment appears to be below the non-accelerating inflation rate of unemployment and inflation and wage pressures are rising then central banks raise their policy rate in order to discourage lending and new money creation.

The challenge central banks face in controlling inflation is that the neutral or natural rate of interest is unobservable. No one knows what that rate is, and it can change over time.

Deflation and Inflation Targeting

Each country’s central bank has a target inflation rate. In most developed countries that target inflation rate is 2% or less. No country has a target inflation rate of zero.

Central banks prefer a low but non zero target rate of inflation because they worry a great deal about falling prices, which is called deflation. Deflation is the opposite of inflation. Deflation can arise when the money supply has stagnated or is contracting because loan balances are falling.

Once deflation takes hold, it can be difficult to combat because households and businesses stop buying in anticipation of further price declines. This in turn, further slows the economy and increases unemployment, leading to a downward deflationary spiral, as businesses lower prices even more as they try to spur demand.

A deflationary mindset by households and businesses can be stubbornly persistent, as the private sector puts off spending and borrowing because they believe prices will fall further.

In addition, during the economic turmoil that accompanies deflation, individuals want to save more, spend less, and not borrow money out of fear they could lose their jobs. That reduced demand can push businesses to lower prices even more, leading to even greater deflation, particularly if the money supply contracts because the amount of loans outstanding in the economy is falling.

Differences Between Inflation and Deflation

Inflation Anchoring

Central banks prefer that households and businesses expect and act as if inflation will stay low, but not too low. This inflation anchoring makes monetary policy easier as households and businesses are less likely to overreact to either rising or falling prices.

Inflation anchoring is when households and businesses act as if inflation will stay low.

For example, if the private sector believes inflation is accelerating, households and businesses might hoard goods and increase their purchases, which can lead to more capacity constraints. Employees might demand higher wages and businesses might increase their prices in anticipation of cost increases from their suppliers. These actions can exacerbate inflationary pressure.

Having the private sector anchored to a low but non zero inflation rate allows central banks to keep their interest rate policy target above zero. That means there is room for central banks to cut their policy target to help stimulate loan demand when the economy is slowing.

During periods of deflation, interest rates often fall close to zero, which makes it more difficult for central banks to stimulate the economy without resorting to unconventional policy tools like negative interest rates.

In 2020, the U.S. Federal Reserve announced its willingness to let U.S. inflation levels run above its 2% target so that over time it averages 2%.

“Inflation expectations are…not directly observed, and must be imperfectly inferred from surveys, financial market data, and econometric models. Each of these sources contains noise, as well as signal, and they can and sometimes do give contradictory readings.” – Richard Clarida, Federal Reserve Vice Chair

Federal Reserve Chair Jay Powell said “If inflation runs below 2% following economic downturns, but never moves above 2%, even when the economy is strong, then over time inflation will average less than 2%. Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below our inflation goal, and pull  realized inflation down.”

The Fed believes that if inflation stays below the 2% target for too long, then inflation expectations will fall and be anchored at too low of level, increasing the risk of deflation during an economic crisis.

Asset Price Inflation

An increase in the money supply does not always lead to higher inflation right away. Households and businesses flush with cash may prefer to own assets that they believe will keep pace with inflation rather than spend the additional money on consumption goods and services.

If households and businesses are willing to pay more for assets, such as stocks and real estate, that can cause those asset prices to increase. This is known as asset price inflation.

Rising asset prices are not factored into official inflation statistics such as the U.S. Consumer Price Index. The CPI measures the price changes in consumption goods and services not in the price of investment assets.

While house prices are not included in consumer inflation measures, house prices influence inflation indirectly. Government statisticians don’t measure the cost of houses in order to calculate inflation. Instead, they measure the cost of living in houses. That means they survey renters to find out what they pay in rent.

They also ask homeowners how much they would charge if they would rent their primary residence. This latter measure is called owners’ equivalent rent.

When home prices increase, it eventually shows up in higher inflation as owners’ equivalent rents increase, but there is usually a lag.

Podcast Episode: Is Another Great Inflation Coming?

Does the U.S. Consumer Price Index (CPI) Overstate or Understate Inflation?

Earlier we learned that inflation measures the rise in prices over time as reflected in hundreds of goods and services purchased by consumers. As time passes, however, consumer preferences change so the mix of goods and services households purchase changes.

In addition, the quality of goods and services improves. For example, the storage capacity and speed of mobile phones have gotten better over time. Also, automobiles are more powerful and safer.

Government statisticians that calculate inflation have to adjust the product mix that comprises the reference basket to reflect changes in consumer preferences. These statisticians also have to separate out price increases due to quality improvements from those due to rising costs. At times, a product’s price could stay the same, but the quality might be greater, which means that the price actually dropped after adjusting for the quality improvements.

Statisticians adjust the product mix and weights in the reference basket used to calculate inflation because inflation benchmarks such as the U.S. Consumer Price Index measure changes to the cost of living rather than simply the change in prices.

A cost of living index, according to the Bureau of Labor Statistics, “measures changes over time in the amount that consumers need to spend to reach a certain utility level or standard of living.” In other words, what consumers buy and how much they are willing to pay changes based on how consumers measure their satisfaction with life.

Some individuals, such as John Williams of Shadow Stats, believe the U.S. Consumer Price Index understates the rate of inflation because the product mix in the reference basket has changed. He doesn’t believe CPI should be a cost of living index, but it should measure the price changes of a static mix of goods and services. Inflation rates would be much higher than official statistics if the reference basket mix stayed the same and there were no adjustments for quality improvements.

Others believe inflation is understated because government statisticians are not aggressive enough in adjusting official inflation statistics to reflect product improvements and substitutions. Substitutions are when consumers swap out more expensive products for those that are cheaper and nearly as good.

The bottom line is there is a lot of subjectivity when it comes to how inflation is calculated. That is why central banks target a low but non-zero rate of inflation. If the target inflation rate was zero, it is possible a country could be experiencing deflation but not know it given all the vagaries in calculating the official inflation rate.

Podcast Episode: Is Inflation Measured Wrong?

What Is Hyperinflation?

Hyperinflation occurs when prices are rising by more than 50% per month. Periods of hyperinflation, such as what occurred in Zimbabwe in 2008 and 2009, and what Venezuela is experiencing today, can see inflation rates higher than 10,000% per year.

Venezuelan journalist Virginia Lopez Glass wrote, “Inflation is bad, but hyperinflation is a totally different game.” Hyperinflation can destroy an economy. Attempts to stem the hyperinflation through price controls cause businesses to stop producing because they can’t make a profit. Store shelves go empty and people struggle to get enough to eat.

What Causes Hyperinflation?

Hyperinflation is caused by a massive increase in the money supply coupled with a severe contraction in the supply of goods and services. The spike in the money supply is not due to bank lending. Rather the federal government, led by corrupt leaders, spends substantially more than it receives in tax revenue. By some estimates, the Venezuelan government has stoked hyperinflation by running budget deficits equal to 30% to 40% of the nation’s gross domestic product (GDP). GDP measures the value of goods and services produced in a country.

Such extraordinary levels of spending lead to a lack of confidence in the government. The country’s currency plummets in value relative to other currencies. This causes the prices of imports to spike, which further exacerbates the hyperinflation.

Hyperinflation occurs because governments essentially run the printing press to pay for things. They often do this because leaders have tenuous political control so they want to reward factions that help keep them in power, such as the military.

Hyperinflation can also result from a lack of confidence in the central bank and the currency it issues. If commercial banks no longer want to hold deposits at the central bank and choose to redeem those deposits for printed currency, then the huge increase in the money supply could also lead to hyperinflation.

Some of the same forces that cause hyperinflation can also result in high inflation without the government running extraordinary budget deficits. If households and businesses lack confidence in the central bank and federal government they may be less willing to hold the currency and invest in government bonds. That can lead to higher interest rates, falling currency prices and rising import prices that feed into higher inflation.

How to End Hyperinflation

Hyperinflation ends only when governments stop expanding the money supply by overspending and households and businesses have faith in the currency again. This usually requires pegging the value of the currency to a more stable currency such as the U.S. dollar. Or even replacing the local currency with the U.S. dollar like Zimbabwe did in 2009 in order to end its hyperinflation.

Often credibility in the government and currency can only be reestablished with a leadership change or by bringing in a neutral third party like the International Monetary Fund to monitor spending and provide financial assistance.

Characteristics of Hyperinflation

• Caused by a massive increase in the money supply.
• Government spends much more than it receives in taxes.
• Often leads to a jump in import prices as currency plummets.
• Can lead to shortages due to a rise in the black market and disincentives to produce goods and services.
• Ends when overspending stops and confidence is restored, often by pegging the currency to a more stable currency like the U.S. dollar.

Podcast Episode: What Causes Hyperinflation and What To Do To Prepare For It

Is Inflation Bad?

Clearly, hyperinflation is bad because it arises due to corrupt leadership and indiscriminate spending. High inflation is also bad because it signifies demand has exceeded the capacity of the private sector to produce goods and services. High inflation indicates central banks are losing their ability to both control inflation and keep inflation expectations low.

Low levels of inflation, however, are not inherently bad. Low inflation is part of a modern economy. Inflation exists because bank lending leads to the expansion of the money supply. Central banks allow for some inflation because it provides room to cut interest rates when an economy is slowing and provides enough of a cushion to protect against deflation.

Even though low inflation is not inherently bad, it does extract a cost as prices rise over time. A dollar worth of goods or services in 1967 would cost $7.33 today. Or put another way, a dollar today in terms of its purchasing power is equivalent to 14 cents in 1967.

The long-term cost of rising prices requires individuals to save and invest in a way to offset the inflationary impact.

Three Inflation Schools of Thought

• Monetarists: Inflation is primarily caused by an increase in the money supply
• Keynesians: Inflation is primarily caused by capacity constraints and too much bank lending
• Fiscal view: Inflation is primarily caused by a lack of confidence in federal governments and central banks leading to a devalued currency and rising import prices

How Can Investors Protect Against Inflation

Investors can protect against inflation by owning assets and investment vehicles that perform better than inflation over the long-term. That means the investments have a positive real return.

An investment’s real return is calculated by subtracting the inflation rate such as the Consumer Price Index from the nominal rate of return on the asset. An investment’s nominal rate is usually the rate of return reported by the investment’s sponsor.

Typically assets with higher long-term expected real rates of return also exhibit higher volatility in that the returns can vary significantly from year-to-year. Due to this volatility, higher real returning assets can go through short-to-intermediate term periods when they lag the rate of inflation.

Inflation-Indexed Bonds as Inflation Hedges

Inflation-indexed bonds such as Treasury Inflation Protection Securities (TIPS) and Series I Savings Bonds are the surest way to perform in line or better than the inflation rate. That’s because the value of these bonds is adjusted based on the inflation rate. Consequently, an investor can be quite confident of their inflation protection.

Unfortunately, the surety that the bond will keep pace with inflation also means the real rate on these bonds is low. In May 2022, the real yield on 5-Year TIPS was -0.4%. A negative real yield for TIPS means the bonds could lag behind inflation by the real yield amount; in this case by 1.0%.

The Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL) is an exchange-traded fund that seeks to protect against inflation by investing in both Treasury Inflation Protection Securities as well as options contracts. You can find a review of IVOL here.

To learn more about inflation-indexed bonds, check out A Complete Guide to Investing in TIP and Series I Savings Bonds.

Stocks as Inflation Hedges

Stocks have been a good inflation hedge over the long-term as they have exhibited a positive real return of 4% to 9% depending on the time period and stock index measured. Stocks represent equity ownership in publicly traded companies.

Most companies are able to pass rising costs on to their customers so that profits and the share of profits paid to stockholders in the form of dividends rise greater than the inflation rate. Stock prices are volatile so stocks can trail inflation over the short-to-intermediate term in a down market.

While stocks have outpaced inflation, equity performance has been better during periods of low inflation. U.S. stocks as measured by the S&P 500 Index have returned double digits on an annual basis when U.S. inflation as measured by the Consumer Price Index is below 4%, according to data from Ned Davis Research. When the CPI has been greater than 4%, U.S. stocks have returned 1.2% or less.

Periods of high inflation usually result in higher interest rates, which can cause stock valuations to fall, leading to lower returns for stocks.

The Horizon Kinetics Inflation Beneficiaries ETF (INFL) is an exchange traded fund that seeks to protect against inflation by investing in stocks. The ETF focuses on well managed publicly-traded companies that don’t need high inflation to be successful, but nevertheless, will benefit if inflation picks up. Examples of stocks that fit this category include royalty trusts that own land and mineral rights.

Real Estate as Inflation Hedges

Rental real estate, including publicly traded equity real estate investment trusts or REITS, have also been great inflation hedges, exhibiting positive real returns over the long-term. Property owners are able to increase rents over time to compensate for inflation. As a result, the value of the rental properties and equity REITs also keep pace with inflation, although REIT prices are volatile like stocks so REITs can lag inflation in the short-to-intermediate term in a down market. In most periods, equity REITs dividend growth has kept pace with inflation.

To learn more about investing in equity REITs, check out A Complete Guide to Equity REIT Investing.

Gold as an Inflation Hedge

Gold has performed better than inflation over the long-term, but it has also gone through lengthy periods when it has lagged inflation. There is no cash flow with gold. So unlike real estate and stocks that can see their cash flows increase by the rate of inflation, the only way gold will outperform inflation is if investors bid up the gold price in the future. Historically investors have, but there is no guarantee that gold will continue to perform better than inflation. Consequently, stocks, real estate, and TIPs are better inflation hedges than gold.

To learn more about investing in gold, check out A Complete Guide to Investing in Gold.

Other Commodities as an Inflation Hedge

Most other commodities such as oil, natural gas, industrial metals and agricultural products have performed better than inflation in the long-term, but similar to gold they have lagged the inflation rate for lengthy stretches.

In addition, most commodities cannot be held directly in the same way that an investor can own gold. Consequently, investors have to invest in commodities futures directly or via a mutual fund or ETF that owns commodity futures. The complex pricing and structure of commodity futures makes them less attractive as an inflation hedge compared with TIPs, stocks, and real estate.

To learn more about investing in commodity ETFs, check out this guide.

Conclusion

Inflation rates fluctuate based on the strength of the economy and actions by the private sector, central banks, and commercial banks. Rising inflation reduces household and business purchasing power over time. Fortunately, there are investments available that allow individuals to stay ahead of inflation and growth their wealth on a real, net of inflation basis.

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