While rampant inflation continues unchecked globally, the US appears to be dealing with this issue better than most. To this end, the annual inflation rate stateside slowed to just 6% in February, its lowest level since September 2021.
Remember, inflation also declined to 6.4% in January, so there’s no doubt that the Federal Reserve’s hawkish monetary policy and aggressive base rate hikes have had the desired effect in recent quarters.
However, inflation remains a stubborn problem for the US government and its subjects, especially given the Fed’s target rate of just 2%.
But what are the exact effects of inflation on businesses and investors, and does this provide a problem or opportunity in the current economic climate?
Appraising the Effects of Inflation
In economics, inflation rates measure a sustained increase in the price level of specific goods and services within the economy, usually over a specified period.
When inflation and the price level rise, each unit of currency buys fewer items, and the purchasing power of the US dollar declines. Conversely, a fall in inflation increases the purchasing power of currencies incrementally, enhancing the buying power of businesses and consumers alike.
Now, subtle hikes in inflation within the central bank’s target of 2% aren’t usually an issue, as a small amount of inflation helps theoretically increase production output when the economy is failing to run at full capacity.
However, the recent surge in inflation (which peaked above 8% in the US alone) causes currencies to lose huge swathes of their purchasing power and become increasingly devalued, increasing operational costs for international businesses and eating into the profit margins in the process.
At the same time, consumers’ purchasing power and overall confidence level also decline, creating a scenario where some price points may become unsustainable, and company turnovers may suffer significantly over time.
Interestingly, economists continue to observe an inverse relationship between inflation and interest rates, so the latter is often hiked to help combat the rising cost of living. The theory is that higher inflation rates encourage households to save rather than spend, forcing businesses to automatically lower their prices over time.
While this is less effective in instances where the inflation rate is disproportionately high, it can drag on the cost of living and help drive lower food and energy prices.
However, it also has the short-term impact of increasing the cost of borrowing and mortgage repayments in some instances, directly affecting businesses and squeezing household budgets even further and at the worst possible time.
The Positive Effects of Inflation – Can it Create Opportunities?
Given the role that inflation can also play in a growing and healthy economy, it stands to reason that this phenomenon should have an array of positive effects.
These include the potential lowering of unemployment due to nominal wage stickiness, which subsequently triggers increased demand for labor and high job creation and fulfillment rates.
Governments may also see increases in tax revenue due to higher levels and so-called “bracket creeping” as individuals transition into higher income tax brackets or begin to pay increased sales taxes in line with higher earnings.
These reasons explain why most economists argue that inflation levels of between 2% and 3% benefit an economy, especially one that wants to optimize productivity and the power of the labor force.
The question remains, of course, is this fact alone mean that inflation can be considered an opportunity? Well, much depends on your outlook and the nature of your business venture, while investors can leverage inflation to create opportunities to utilize market volatility to their advantage.
From a business perspective, inflation rates that continue to rise faster than wages enable companies to increase their pricing without immediately losing customers. Inflation may also create demand for new products and services as households look to cope with higher living costs, although neither trend can be sustained indefinitely over time.
As for investors, they can use vehicles like forex to hedge against currencies that are most devalued by inflation, such as the GBP. Currently, inflation in the UK is running above 10% due to additional factors like Brexit and its impact on the supply chain, so the pound is expected to lose ground against the US dollar and Euro in the short-term at least.
This opportunity exists thanks largely to the speculative nature of forex trading and the fact that investors don’t have to assume ownership of the underlying asset. At the same time, it highlights the fluid nature of the financial markets and the positive effects of factors like inflation and volatility.