Inflation

Do you believe the statement: Is Inflation bad for the economy?

Kyle Wales, portfolio manager at Flagship Asset Management, gets into the nitty gritty of how inflation works and explains why it is bad for economic growth.

Risks

Risks remain to the upside. This is evident from the fact that the dispersion around 2023 forecasts has increased. Some banks expecting inflation to be as high as 3.6% in 2023.

War in Ukraine

The removal of Russia from global markets will have a huge impact globally. This is due to the outsized role Russia plays in many of these markets.

Commodities as diverse as crude oil, petrochemicals, wheat, nickel, diamonds, and platinum-group metals are involved, Russia is either the largest or second-largest producer of these. The rise in the price of oil to north of $130 per barrel will be most keenly felt. The reason is simple: it affects the prices of a myriad of other items.

Is moderate inflation bad?

Academic research on the subject is actually divided as to whether moderately high inflation, which is currently the case, is bad for the economy.

It is only when inflation crosses a certain (high) threshold, that opinions on this subject begin to align. When this high level is reached, there are three main reasons why it has deleterious effects on economic growth.

Purchasing power is eroded

Ordinary people have less money to spend on discretionary items. Consequently, the businesses which sell these items experience a decline in their sales.

Investment is discouraged

Very high inflation is bad for the economy is because it discourages investment, which is a key driver of economic growth.

When inflation is very high, people are less likely to leave money sitting idle in their bank accounts. It is this money which banks loan to aspiring entrepreneurs to invest in physical capital or invest in productivity-enhancing measures.

Inflation is bad for asset prices

Very high inflation is bad for economic growth as it is bad for asset prices. Equities are one of the most effective assets to hold as inflation rises, at least until it reaches the 5% level.

In economics there is a behavioural effect known as the “wealth effect” which suggests people spend more money as the value of their assets rise. This provides stimulus to the economy as a whole. The inverse is also true. When the value of people’s assets decline, they spend less and this withdraws stimulus from the economy.

Summary

Holding commodities and gold will serve investors well should inflation expectations become unanchored.