TSI #14: When will inflation go down?

Hi everyone, today I want to share my perspective on inflation.

By having the right expectations about inflation, you can adjust your behaviour as an investor and profit from the situation - whenever possible.

So today we are going to cover:

1. Why inflation happens
2. Where are we now
3. What we can expect from the future

Let’s start!

Why inflation happens?

Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair. - Sam Ewing

Everyone here is likely familiar with inflation.

Inflation can be defined as the fall in the purchasing value of money.

Inflation at normal levels (around 2%) is a good thing:

1. If people expect prices to rise, they tend to buy more stuff before the prices rise. Buying more stuff boosts the economy (more products → more jobs → more wealth)
2. Debts become less heavy.
   Imagine that you owe $100 in 2000. If you repay your debt in 2020 by giving back $100 you technically paid back less - as $100 in 2020 are worth much less compared to 2000)

This is why governments and central banks use their financial power to control inflation and consequently boost the economy.

Inflation growth is controlled through the money supply: the more money there is around, the less each unit is worth, reducing the purchasing price.

Why?

Imagine that there are only 5 Rolex in the whole world. The value of each one of them is likely to be high, as they are rare.

Now imagine that there are 5,000,000 Rolex in the world. The value of each unit is going to be lower.

In a very simplified way, this is why you buy much less stuff with $5 compared to 20 years ago. There is just much more money around.

In 2020, central banks had to use all of their financial power to stimulate the economy and recover from COVID.

In particular, central banks focused on lowering interest rates.

With lower interest rates, people and business can borrow money in an easier way, stimulating once more the economy.

However, the main way to lower interest rate is… Increasing the money supply.

So here we have the whole situation:

1. COVID caused economy decline
2. The central banks lowered interest rates aggressively to boost the economy
3. By doing so, they increased the money supply
4. An increase in the money supply caused inflation to rise exponentially

Where are we now?

At the beginning of 2022, it was clear that the main threat was not economy decline - but inflation.

So the central banks made a literal inversion of actions, focusing on raising interest rates aggressively, with the goal of reducing the money supply and stopping inflation.

Is it working?

A simplified analysis of August 2022 data would say absolutely not:

Inflation is still running high.

But is this the right way to look at the situation?

What can we expect in the future?

The reality is that the economy is not a very reactive machine.

Central Banks actions are seen in the economy with a delay of 18 months on average.

Interest rates started to go up in January 2022.

This means that we could see inflation to slow down in the summer of 2023.

This, of course, does not consider unpredictable outcomes such as the Ukraine war.

So buckle up, as we are likely to have still some difficult months ahead of us.

There is one great thing though: you can be sure that the stock market will react in ridiculous ways every time a new monthly report on inflation is announced.

My personal suggestion is to take advantage of every red day ahead of us…

Buy low and resist, Stoic Investors!