A Beginner's Guide to Inflation

What do today's macro-economic headwinds mean for ordinary people?

"Inflation & Gold" by Paolo Camera is licensed under CC BY 2.0.

Russia’s invasion of Ukraine in February sent shockwaves through the globalized economy. The West responded to the unjustified invasion with robust sanctions on Russia; and the aggressor responded to the sanctions by cutting off gas to Europe. In 2021, Russia had supplied 40% of the gas consumed in the European Union (EU), with more than 50% of Germany’s gas coming from the east.

Lower supply equals higher prices, as any student of economics will tell you. Gas prices soared as a result of the shock. This has had a knock-on effect on electricity prices throughout Europe for a simple reason - combined-cycle plants use gas to generate electricity at peak times. At the same time, oil prices have soared - Europe used to receive around half of Russia’s oil.

Imagine that you run a factory. The price of electricity is probably your main expense. With soaring prices, you have no choice but to make your wholesale prices more expensive to cover your costs. Retailers also have to ramp up their own prices as soaring oil prices make it much more expensive to move the product from the factory to shops.

The result is rampant inflation throughout the economy. Economists have long known that fast-rising prices are a curse for society. Your savings become devalued; it gets harder and harder to get to the end of the month with any dignity; and inflation encourages people to spend most of their salary on payday. Trade unions and employees - quite reasonably - demand large increases in wages to keep up and it leads to even more inflation as employers raise prices again. Everyone loses.

For more than a decade before the invasion of Ukraine, inflation hadn’t been an issue in the EU, the US or Japan. Central banks responded to this benign environment by experimenting with negative interest rates, making debt cheap and cash a poor investment in many circumstances*. It is no coincidence that crypto-currencies - which mostly don’t have any yield but are wildly unstable - became popular during the time that deposit accounts in fiat currencies also didn’t yield any income. Of course, crypto prices have crashed as inflation once again reared its ugly head.

Central banks know exactly how to fight inflation, but unfortunately the method is just as drastic as fighting cancer with chemotherapy. The cure is almost - but not quite - as bad as the disease, at least in the short term. The answer is to ramp up interest rates, which means that deposit accounts in fiat currencies should start providing yield again.

The European Central Bank (ECB) recently bumped interest rates by 75 basis points - a huge amount. The Bank of England in the UK and the Federal Reserve in the US are also raising rates, although the Bank of Japan plans to stick with low rates.

Central banks set base rates for the whole banking sector. Retail banks use the base rate as a benchmark as they set interest rates for their customers. The most immediate effect of rising rates is felt by home-owners with variable-rate mortgages, who suddenly have to pay a lot more every month. As a result, many families find themselves with less disposable income. This makes them less likely to take an expensive foreign holiday or buy a new car.

A more subtle effect is felt by companies. Those that have heavy debt loads will find it harder to make their interest payments. Some will have to go out of business, while others will try to survive by slashing their workforces.

The combination of families spending less and soaring unemployment as a result of higher interest rates is likely to trigger a recession, which is six months (two quarters in financial jargon) of negative overall growth. A recession means that aggregate demand for goods and services in the economy tends to fall, which helps rebalance prices (remember that inflation was caused by supply-side shocks). The readjustment won’t be pleasant, but it should defeat inflation, which paves the way for lower interest rates in the future.

What can ordinary people do to prepare for a recession? At times like this, the time-tested advice to spend less than 40% of your family income on mortgage payments really comes into its own, along with advice not to go into debt for consumer products and to pay off your credit card in full every month. If you followed this advice, you should be able to cope as your monthly mortgage payments soar. If you didn’t, now is a good time to talk to your bank manager about your options.

Now is also a good time to think about the safety of your job. Going into a recession, it is better to work for well-established and profitable companies with little debt. Companies that loaded up their balance sheets with cheap debt in the good times become risky bets when interest rates are rising; and smaller companies can be more fragile than larger ones. Being a key member of a lean team is probably safer than being a middle manager surrounded by dozens of other middle managers. If your job is at risk of automation in usual times, a recession can be particularly scary. Startups look less attractive than usual in a recession, although those that not only survive but also thrive in a bad economy can be a great bet afterwards.

I am not regulated to give investment advice, but it is worth thinking about “counter-cyclical” investments at times like these. Debt collectors and the like often do better than other companies in recessions. Please speak to a qualified investments advisor before making any drastic changes to your portfolio.

Of course, this whole article is based on the premise that the Ukrainian war will drag on for months. Given recent advances by the Ukrainian army, this isn’t necessarily the case. If Russia loses, there is a chance that Vladimir Putin’s regime could collapse suddenly. Would his successor turn the gas back on? And, if so, would prices suddenly start to plummet? The comments are open. See you next week!

Further Reading

Antifragile by Nassim Taleb

*There is one big exception to cash being a bad investment. Ordinary people should have enough cash on hand to survive unexpected shocks, like a broken car or a period of ill health. Enough money to survive a few months without any income is a good rule of thumb.

Sharpen Your Axe is a project to develop a community who want to think critically about the media, conspiracy theories and current affairs without getting conned by gurus selling fringe views. Please subscribe to get this content in your inbox every week. Shares on social media are appreciated! If this is the first post you have seen, I recommend starting with the first-anniversary post, which includes links to a free book.

Opinions expressed on Substack and Twitter are those of Rupert Cocke as an individual and do not reflect the opinions or views of the organization where he works or its subsidiaries.