Inflation, a fundamental number for the economy and for investment choices. Let’s see together why.
Many hear of inflation and many underestimate its importance both economically and in terms of investment choices.
What is inflation? Why is it so important?
Inflation is a number that indicates the increase (or decrease) of consumer price level over a certain period of time, usually a year. To give a very simple example, if annual inflation is 5% it means that current prices are 5% higher than last year.
Inflation is fundamental for the economy because it indicates, with a certain degree of approximation, its state of health. For example, inflation that stays at 2% for 3 years indicates that prices in an economy rise by 2% each year and this indicates that "the money is spinning" and that the economy is moving .
Conversely, an economy with negative inflation, indicates an economy that does not move, where the "money does not turn" and for this reason prices remain frozen or even go down. When we have negative inflation, we are faced with one of the most dangerous phenomena for an economy, that situation which is called "deflation".
Inflation, why does it rise and why does it fall?
The famous expression "money runs" was a way of introducing the concept of "Speed of Circulation of the Coin". In fact, the faster the money circulates, the more the economy moves, the more inflation rises. Conversely, the less money circulates, the less the economy moves and inflation falls.
The speed of this "machine" is controlled by a pilot named "Central Bank". The central bank (in the case of Europe, the ECB) has as its main task that of Inflation Targeting, namely that of keeping inflation stable within a target, an objective.
Each central bank has its own inflation target which, in the case of the ECB, is close to or equal to 2%. Obviously, central banks have a wide range of tools to control inflation, both to raise it and to bring it down, all to the advantage of economic stability. If the central bank has problems in containing inflation (or deflation), the economic-financial sector will “self-regulate” through supply or demand crises.
The current situation: hyperinflation
We have said that the ECB has an inflation target close to or equal to 2%. In Europe, we now register a figure of close to 8% (to be precise 8.1%) on an annual basis, a situation that macroeconomists should define as Hyperinflation.
It is defined as a phenomenon of hyperinflation when we have inflation above the target for a prolonged period of time. The case of today’s Europe could be a clear example of this, yet few are unbalanced by telling the truth about the current situation, that is, few speak of hyperinflation.
What do you do in these cases? In these cases, the central bank, the ECB, must act on the "speed of circulation of money". But how can he do it? For example, one of the main instruments is the interest rate, which is the cost of money. The more the money costs, the less quickly it will circulate, this is the rule. So, one way to cool the price increase (hyperinflation in this case) is to act on interest rates.
It is important to keep in mind that each central bank has a pool of economists who are involved in economic projections related to containing inflation, so it is not very easy to understand how a central bank can actually act.
Many economists, in the current situation, have exposed themselves by placing a legitimate doubt about the absence of action by the ECB on the rate of acceleration of inflation (from 2% to 8%).
Inflation and investments
Inflation, as mentioned before, indicates price increase and its value is representative of the health of an economy. So, an economy with 2% inflation is healthy so why not invest? Rule has it that inflation decreases the "real" returns on an investment. Let’s see an example together: if I make an investment that made me 4% in a year, the real return is that net of inflation, that is (4% -2%).
In essence, healthy investment is always higher than inflation. An economy with stable inflation, therefore a healthy economy, must guarantee returns above inflation.
