Those who have read our previous newsletters know that inflation is actually a second form of taxation that is caused by government action, and acts by eroding the purchasing power of dollar-denominated assets.  The inevitable ‘next question’ is to find out what inflation means to us, and how we can fight against it.

The best place to start answering this question is to explain what inflation does.  Since inflation erodes purchasing power, it effectively transfers wealth.  Inflation transfers wealth from lenders to borrowers because the lenders are contractually obligated to an interest rate that becomes less and less relevant as the currency devalues.  On the other side, the borrowers are paying their loans back in dollars that have declined in value.

Inflation also transfers wealth from retirees to workers.  The reason for this is because retirees typically have their ‘nest egg’ invested in ‘safe’ assets such as Certificates of Deposit, government bonds, and other financial instruments whose principal value is guaranteed by the government.  The transfer of wealth happens because the interest rate for these ‘safe’ instruments gets eroded by inflation as the net purchasing power of the retiree’s nest egg declines.  Conversely, workers wages tend to increase with inflation as competition between employers for skilled labor drives up wages to the new rate of equilibrium.

So how do we fight against inflation?  The unfortunate answer to this question is to work against the advice that many of us have received throughout the majority of our lives.  Many people operate under the belief that the way to long-term wealth is to save, invest, and eliminate all debt.  While it is true that this plan will definitely make you better off than not saving or investing, it will still leave you very vulnerable to the impacts of inflation.  (Especially when the unfunded Social Security & Medicare obligations come due)  The best way to fight back vs. inflation is to make investments in appreciating assets that produce income by borrowing money for a long time at a fixed rate.  The reason for this is because the income from the assets will help to pay the interest expense.  Over time the impact of inflation will cause the value and income of the asset to appreciate, and will also allow you to repay the fixed-rate loans in devalued dollars.