People all around are talking about how much more prices have risen. Hearing them talk about the higher prices sparks my curiosity about the high inflation we perceive and what we should know about it.
One lady at the store said a drink she bought went up in price. I asked her, “Has it? What’s the price difference?” She said, “Just last week, I bought some for 50¢. Now it’s 58¢, in just one week.” I heard another say,” I can’t believe the cost of 60 eggs is now $16.00″ I hadn’t bought a case of 60 eggs before, but she seemed to have noticed a price difference enough to speak it.
So, at the basic level of understanding, you don’t need to know much more to see that inflation is much higher, consumer prices are rising, and living is more expensive. You are experiencing it.
Why is the cost of living rising?
From the research that I’ve done, we need a better understanding of the word inflation. A lot of people think inflation means price increases in goods and services. That’s how I understood it too. We say, oh wow, the prices of things sure are getting expensive, but then stop there and question why the prices rose no further.
I thought, what is causing higher inflation? Why do we have to raise prices? Why is inflation causing energy and food prices to rise? No matter what the circumstances are around us, who’s in charge, who’s not, and who’s to blame, the prices of goods and services always seem to rise, and inflation occurs. So, I wanted to know what inflation really meant.
What is the more accurate definition of inflation?
The more accurate definition of inflation is an increase in the money supply. The rising prices of goods are an effect of it. A by-product, if you will. So, when you notice the prices of your favorite food or product rising in cost, think about the actual definition and what’s happening behind the scenes.
You may hear oh, price levels are rising because of the supply chain. Or this or that. The rising prices are simply because the supply of cash is increasing. The more you have of something, the less valuable it is.
In the case of fiat money, the more that is being created, the less valuable it becomes, so it buys less. The more cash there is to chase goods and services, the higher the prices will rise to balance the supply and demand.
So who’s creating more money and causing inflation?
This topic is interesting. I know of two main ways money, or fiat, comes into existence. From my understanding, the Federal Reserve, which is a central bank, creates inflation by:
Purchasing assets from the banks, which
Then gives banks money, then
That money is circulated into the economy.
This operation is called Open Market Operations and is part of their monetary policy toolbox. How it works is that the Federal Reserve and other central banks buy securities (treasury bills, notes, bonds, inflation-protected securities, and floating rate notes) through auctions from dealers. The dealers, also known as primary dealers, bought these treasury securities from the government.
More Detail:
Treasury securities are just debt units that the U.S. Department of the Treasury issues to help fund government operations. They are basically IOUs written on paper and given to the lender as a promise that the government will repay the lender for loaning them money.
Fiat is money issued and controlled by a government not backed by a commodity such as gold.
Primary Dealers have direct access to sell to the Federal Reserve. Can you guess who the primary dealers are? Yes, it’s the banks and financial institutions. Some examples of primary dealers are Bank of America Securities LLC, J.P. Morgan Securities LLC, and T.D. Securities (USA) LLC.
This operation increases the money reserved in the banking system. Banks are required to always have a certain amount of cash that they can’t loan out, like savings. Since the banks now have more reserves from selling treasury securities, they can trickle down the excess reverses into the banking system. Now, there’s more fiat available to give out more loans to the population for their needs.
This process puts more cash into the banking system because when the central bank buys these securities from the primary dealers, they add cash electronically. That’s right, that money didn’t exist. Central banks cause inflation and price increases with this process. This is one of their tools to influence the system’s money (debt) supply.
That’s like sitting at your computer looking at your $5,000 bank account. You decide you want to buy a new house. You’ll need more cash to do that, so you will type in a couple of zeros. Now, you just created more cash to buy your house. Where did that cash come from? Exactly, from nothing, you just added cash into the system, which causes inflation.
More Information:
William J. Luther elaborates on this process in more detail.
Investopedia goes into more specifics on how this tool is used for monetary policy.
Fiat is also coming into existence this way. If I were to take out a loan from my bank, they would credit my account with the amount I requested if they had a certain amount of reserves. The cash credited to my bank account does not really exist; hence another way banks create inflation.
Let’s say I have $10,000 in my pocket that I’m storing for someone else. You came up to me and asked me to borrow $9,000. Well, I don’t have the cash, but because I have specific rules that apply to me, I will:
Keep 10% ($1,000) in reserve and loan out the $9,000 left to you. I keep 10% just in case the other person I’m holding for wants to withdraw some cash.
Meanwhile, I left the other person I borrowed from with I owe you notes.
Then, I’ll create money by entering numbers on a computer screen and credit you $9,000 with interest. Thus, I now have a total of $19,000 (The I owe you notes and the $9,000 credit I loaned out are both assets).
Meanwhile, that $9,000 loaned out is now repeating the above process and multiplying the money supply even more.
The Fractional Reserve System is the name of this system. It’s a mind-blowing and worthy concept to understand and is part of why we have high inflation. There is this engaging video on YouTube that undoubtedly helped me to understand the topics discussed above:
More Information:
Matthew Johnston helped me wrap my mind around this concept better.
Whattoknow.info has an article that sheds light on this as well.
Now we better understand the Fractional Reserve System and how it adds to the money supply. Here’s another fact we need to know about inflation. On March 15th, 2020, the banks are now required to have 0% reserves. So, now they don’t have to hold any cash deposited into the bank. Banks can now create immeasurable amounts of cash, helping to create the cost of living crisis and is part of what’s causing high inflation.
I wanted to see who controls the reserve requirements set for banks and financial institutions. It turns out that it’s the central bank. They ultimately control the cash supply and inflation in this instance too, which ties right back into the central bankers’ open market policy.
And how is the central bank able to create inflation non-stop?
Gold is no longer backing the U.S. dollar and, thus, is losing its purchasing power. I found this out when I started to research inflation. The central banks can create unlimited amounts of cash and inflation since it’s no longer tied to a limited resource.
This allows the Federal Reserve, other central banks, and the government to control more of how cash operates now that gold is no longer constraining them. They can inflate (and deflate) the fiat supply because they can create (or eliminate) fiat as they see fit.
With gold, the central bankers can only create as much fiat as there is gold. Without gold, central bankers can do as much inflation as they want, which doesn’t allow for a naturally stimulated economy through the actual production of goods and services.
Stimulating the economy by creating fiat isn’t healthy since creating from nothing holds no real value, which is part of why we are in this inflation bubble. A lot of cash today has no real value and shouldn’t even exist; this brings me to my next point.
A lot of cash today is just debt. We must pay this debt back. So, who do we pay back to? The central bank. They created the cash. So, when creating cash, they are just creating more debt. They can create this money (debt unit, promissory note) endlessly. The dollar is losing its purchasing power because gold no longer backs the U.S. dollar. The U.S. dollar was officially off the gold standard in 1971.
Lynette Zang is great at explaining concepts in detail and talks about the difference between being on a gold standard contrary to being off:
Theoretically, they can create as much cash as they want now that gold no longer backs the U.S. dollar.
More Information:
- The History Channel details how and why we are no longer on the gold standard.
- Investopedia is another insightful article that explains how gold no longer backs the U.S. dollar and how this allows for inflation, causing the prices to go up.
Why is knowing what causes inflation and why prices rise helpful to understand?
Falling prices will happen when central bankers stop creating cash, but I don’t see this happening anytime soon without consequences. We’re getting higher prices every day. You don’t need terms like the consumer price index (The consumer price index is used to measure the consumer price inflation rate) or the consumer price inflation rate (aka inflation rate) to tell you that.
It’s beneficial to know why prices rise. We need to know why we have inflation and no price stability. If you have a basic understanding of what’s creating inflation, you’ll have some direction as to what to do to help combat the rise in cost.
You now know that the central banks are creating inflation and raising consumer prices. This knowledge gives you the confidence to know what to do with your cash. It’s hard to decide on something if you don’t know the why behind your decision. You won’t stick with it.
How can we combat inflation?
The high inflation environment is something that many households face. There won’t be lower prices anytime soon, but there are ways to combat inflation. We’ll have to do more than save “money.”
Precious metals are something to invest in. We talk about Why Investing in Precious Metals is Now One of the Best Investment Opportunities. Many central banks are buying gold at a fast pace. I’m a fan of silver, and prices are still low on it.
Cryptocurrencies will play a role as well. It is a highly volatile asset because it is still very much new, and kinks need to be worked out, but just like how the internet changed how we store and transfer information, this will significantly change how we store and handle value. Yes, I am a huge fan of cryptocurrencies.
Certain stocks are bought by people as well. They may invest in stocks that have to do with energy or commodities.
There are other ways to fight inflation, but these are the main ways I know. The safest play is precious metals since, in my eyes, that’s the ultimate base for cash to me, but the others allow for diversification and play a role too.
I’m still pondering how these commodities will initially react when the inflation bubble burst. They could all dip initially, then go back up. A lot of stocks may be wiped out, and maybe only certain ones will bounce back, at least for some time. Either way, since it’s not 100% known, at least from my standpoint at this point and time, this is where diversification comes in.
Now we know what we need to know about inflation and the central banks.
You understand why inflation hits, how the dollar is losing its purchasing power and making prices rise, and how the central and institutional banks play a role in inflation. At some point, this will lead to a financial crisis. It will happen whether or not you want it to and whether or not you prepare. You can look at it as a terrible time or an opportunistic time. What you do with that knowledge is up to you.