During 2020, the US Federal Reserve has printed more than 9 trillion US dollars. That’s roughly 20% of the US dollar going around in circulation today.
In other words, for every $100 that exists today, the United States government and Federal Reserve printed $20 out of thin air in just the last twelve months. This seems like a really bad warning for what there is to come in 2021.
How will this affect us and will it actually be that bad?
First, let’s talk about the value of money and maybe one of the reasons why we are seeing a new surge of bitcoin investors again. We’ll start off with the very basic fundamentals but don’t worry, we’ll dive in deeper after we cover the basics.
The easiest way to imagine inflation is to picture a $100 bill. It’s a piece of paper but we all trust in the value that this piece of paper has. Let’s say we can take our $100 to the department store and buy 100 pairs of socks today. Instead of going out to buy socks, we just keep the $100 in our wallet because we might not need any socks. Next year, we’ve since worn out a bunch of holes in all our socks and so we go back to the same department store to buy socks. Unfortunately, a year has gone by and now we can only buy 98 pairs of socks with the same $100 bill. We got ripped off by about 2 pairs of socks or about 2%. That’s inflation.
We can’t buy the same amount of socks even though the $100 bill we have didn’t change at all. It’s still the same piece of paper it was a year ago except it now has less value. So we can all agree that we’d rather have those two extra pairs of socks and inflation sucks but why did this happen?
The Basics of Inflation
There is a common misconception that the only reason we have inflation is because the Federal Reserve just keeps printing more money. BRRRR goes the money printing machine. Since we have more and more money being magically printed the value of our money should go down since we’ve printed literally trillions of dollars out of thin air. This is correct but doesn’t actually explain all of the reasons we might experience inflation.
Let’s think a little deeper. Socks should actually become cheaper over time. As we continue to make socks, some people have probably made a more efficient or faster sock making machine. We’re able to produce socks much more cheaply and in much larger quantities than in previous decades.
Over time, we will always have technological advancements optimizing everything which will in turn drive prices down.
Unfortunately in this world all the central banks and governments actually want to either keep prices constant or to rise over time. Essentially, their goal is to make our socks cost more next year.
The Reason Banks Want Inflation
Governments and central banks want to maintain a healthy amount of inflation for a few reasons. The first of which is that it encourages spending and consumerism and creates a healthy economy. If we can buy more socks today, we’re definitely more likely to go out and spend our money instead of saving it. The second reason is to help get rid of their debt. As of 2020, America’s national debt is over $27 trillion and growing each day. The prices of goods, services, and wages all rise with inflation. Debt is one of the only things that will not increase along with inflation. In this way, the government will be able to shrink their debt as inflation makes the value of their debt decrease.
One of the tools central banks and governments use is basically just printing more money or currency. A $100 bill is really just a piece of paper that we trust to have a certain value. We trust that these central banks and governments will back up the value held in these slips of paper. Throughout history, we’ve had many examples of what happens when this trust is lost or destroyed.
A very recent example of this happened in Zimbabwe. Most people know that in Zimbabwe their currency is almost worthless. In fact, most people are millionaires in Zimbabwe dollars which is equivalent to a few thousand USD. The currency in Zimbabwe completely collapsed as people lost trust in their government and hyperinflation set in. This can be worrisome to a lot of people especially if we start to see any signs of hyperinflation in America.
Inflation makes all our money go down in value and in effect, we’re able to buy less socks despite technology making it easier and cheaper to manufacture socks. Despite this, the governments and central banks still want inflation. These same governments and central banks literally created 20% of all the currency that exists today in the past twelve months. Yes, that should sound at least a little crazy to you. $1 has been magically created for every $5 that existed prior to 2020.
So how much inflation will we see next year in 2021?
The answer isn’t as simple as a yes or no. We may see some absurdly high increases in inflation year over year especially around March or April 2021.
That might sound terrifying but don’t let those numbers scare you. This year in March and April we actually had really low inflation numbers. That means in 2021 if our economy goes back to normal, the inflation readings doing a year over year comparison to March and April will be much more exaggerated.
To understand why we had such low inflation numbers in March and April, we’ll need to understand how inflation is calculated and what those numbers really represent. The Federal Reserve normally shoots for approximately a 2% inflation rate. That 2% represents the average price increase for all goods and services. Instead of going to the department store just for socks, we’ll pick up a little bit of everything in every industry. We’ll fill our shopping cart with a little bit of retail, a little piece of entertainment, some bits of financial services, a slice of agriculture, etc. After accounting for inflation, our cart is now 2% emptier than the year before.
For example, let’s really focus on our sock example. These socks normally go for $1 per pair but because of the pandemic no one wants to go outside shopping for non-essentials. Sure some people might have worn holes into their socks but they’re much more likely to just keep wearing them instead of risking a trip outside to the department store. The pandemic and stay at home orders have really dropped the demand for all non-essentials and so socks might be selling at a discount and only cost 90 cents now.
Sure, we might have seen toilet paper or Purell be worth their weight in gold but demand for goods and services saw a dramatic decrease on average which caused prices to drop and inflation to look extremely low during the first few months of the pandemic.
In preparation for 2021, let’s go through the three main things that actually cause inflation.
Three Causes for Inflation
1. Inflation can be caused by a ton of demand.
There’s been multiple historical studies on the relation between demand and the post-pandemic time frame. In every case, the data shows a surge in demand during the months directly after a pandemic. In the current case, we’ve been quarantining with measures in place for the good part of ten months.
People are becoming increasingly anxious to go out and spend money to bring their lives back to normal. This has already happened in some effect as airline prices are surging again as more and more people want to travel and we have less airplanes to meet the demand.
Once we see this same demand catch up in other industries, prices will once again rise. We have seen the average savings rate reach record levels during the pandemic. In fact, household wealth just passed the record for the highest level ever met in the United States. As the pandemic situation gets sorted out and life returns to normal, it will be inevitable for people to start spending normally again. This could be one of the catalysts for a huge year of inflation in 2021.
2. Inflation can be caused by worker shortages.
Sometimes things get more expensive to make maybe because people get paid more money or they are fewer workers and prices go up. That’s not good since we’re buying less socks with our $100
Fortunately, we probably won’t see inflation due to worker shortages anytime soon. The Federal Reserve currently doesn’t believe we will hit normal levels of employment until 2023 or even 2024. This might seem strange as millions of people have lost their job to the pandemic. Despite that, an even larger number of jobs have been created. The problem is that many of the jobs lost have been in the service industry whereas the numerous jobs created relate to technology and require higher levels of education in areas such as machine learning or analytics.
Out of these first two drivers for inflation, it seems like the big driver for inflation in 2021 could be an immense surge in demand for goods and services. Aside from the previous example of airline prices increasing, we’ve also seen a price increase for essential goods such as food. The demand in other sectors stays relatively depressed which makes sense as we’re still struggling with the pandemic.
As the current situation gets wrapped up and vaccines are more widely distributed, we might see that immense demand increase to other sectors in 2021.
3. Inflation could be manufactured by the central bank.
This is actually the most worrisome driver for inflation. If the Federal Reserve continues to print money as they currently are, we could soon be experiencing a sort of forced inflation in our economy. After all, 1/5 of all the money in circulation was printed out in a short twelve months.
It is also the cause we have the least amount of historical data points to reference for. What has historically happened when the Federal Reserve printed money like crazy? Well most recently, we can look back at the Great Recession in 2008 where we had over $800 billion created on stimulus. Although this pales in comparison to the trillions created this year, that $800 billion stimulus essentially continued to twelve years of little to no inflation.
Even looking outside of the United States, we don’t see many examples of inflation. In fact, most countries are actually concerned with deflation instead. Japan has been struggling to create inflation in a stagnant market and some parts of Europe have been juggling negative interest rates for a while now.
Central banks and governments have been printing money but in the last couple of decades we don’t have any huge instances of inflation in developed nations. Yet, we’ve also never seen 20% of the money in circulation created almost overnight. Can we really expect to see no inflation in the next few years?
How to protect against inflation in 2021.
Although you might not be able to actually predict how much inflation we’ll see in 2021, you can protect yourself against any inflation that does occur. The solution is to invest into assets such as stocks or real estate that tend to increase in value with inflation. This is because we have a relatively finite amount of stocks of a company and houses built which means the value of your investments(when properly diversified) will grow alongside and above inflation in the long term.
This article is for informational purposes only not all information will be accurate. This should not be considered Financial or Legal Advice. Consult a financial professional before making any significant financial decisions.