Inflation

Definition of "Inflation"

Written by

DeDe Galindo

Prime Properties Realty

One of the many Inflation definitions can be put into these simple words: the result of the general increase in prices over a period expressed as a percentage. Inflation is controlled by Central Banks or by the Federal Reserve in the U.S. by manipulating interest rates. By increasing the cost of borrowing money, these institutions make sure that inflation remains low. People borrow less, so they get to spend less. It is an easy concept based on the law of supply and demand. When the cost of money is high, the demand is low. Policymakers aim for an inflation rate of 2% or lower. But when inflation decreases, it doesn’t mean deflation at all. Deflation starts when inflation is below 0%.

Effects of Inflation

A higher inflation rate reflects in higher prices for consumer goods and a decreased buying power. As inflation increases, money loses their value. For example, let’s suppose the inflation rate gets to 5%. One day before, $100 would have bought you 100 houses. Today, the same banknote would buy you only 95 houses. Inflation is like a rollercoaster – it stays up for a short time than decreases over a period only to get to another peak later. In real estate, inflation plays a key factor, even though it may not seem obvious. However, real estate is an inflation-sensitive investment. Real estate investors will buy when inflation is expected to rise again. The banking system gives the signal. When banks remove restrictions and facilitate credit, then they attract new borrowers and realtors can find buyers for their listed properties. When inflation is high, and loans are hard to get, then is the worst time to sell, because the market will expect a lower price for the same good.

It is thought that commercial projects are safer and less influenced by inflation fluctuations. However, in this post-recession era, when online stores gain a larger market share, competing with physical stores, any increase in rent could result in an empty commercial space, given the fact that expenses increase faster than incomes and wages. The same happens in the residential real estate sector. A rise in inflation does not immediately increase rent prices.

Causes of Inflation

Inflation is tightly connected to our monetary system. Banks and insurance companies possess mountains of cash. Inflation exists because there is not enough cash left for everybody. There is a huge demand for liquidity, and the banks know this. But they don’t release any amount of money without interest which means that money doesn’t enter the economy unless one of us is borrowing. So debt is the cause of inflation, especially long term debt. There is no such thing as free money.

So banks and insurance companies try to lend all that cash to consumers and businesspeople in exchange for a good interest. What happens? Well, the banks will lower the interest rates for a while until people benefit from it and generate an increase in prices through their spending. Insurance companies will invest in bonds and sovereign debt, pumping money in top businesses. There are winners and losers in this redistribution process, of course, but inflation in itself is a cause for more inflation after all.