Is inflation a double edged sword?

If you mention inflation to anyone you will probably strike fear into them as they will automatically think of rising prices and a general increase in the cost of living. However, inflation is a vital element of any healthy economy as long as it is under control and not allowed to move too high. Surprised?

Inflation is perhaps one of the most misunderstood economic factors in the world as people automatically assume that inflation has downsides for every area of the economy when this is just not true. Let us explain :-

Positive impact of controlled inflation

In a controlled inflation environment there are many advantages for the economy and the public with a couple of examples covered below :-

Property Rental

Like any investment the income which you can expect to receive will play a major role in determining the ultimate value of you property. For example let us say the general rental yield in the UK was 10% (in order to simplify the figures) of the value of a property. If you acquired a property for £100,000 then you could expect to receive around £10,000 a year in rental income.

Now let us suppose after year one, inflation was running at 4% which would offer you the opportunity to argue that in order to retain the ‘real’ value of your rental income you could increase the rent payable by 4% from £10,000 to £10,400. On a running rental yield of 10% this would indicate a fair value for your property of £104,000, so next year with inflation at 4% you could increase rental income to £10,816 which would indicate a property value of £108,160 (i.e. 10 times the rental income).

Obviously market conditions and market factors can change but all being equal it is possible to value your property on a rental yield basis.

Business Inflation

Many people will be amazed but inflation is a necessary element of any business sector because the chances are that no matter what line of business you operate in your costs will increase by at least inflation each year.

Suppliers may price their goods on the rate of inflation and introduce annual reviews to retain the ‘real’ value of their income which means that if you have a business you will need to increase your charges to take account of rising costs. In a controlled environment for inflation this is much easier to pass on to customers who can see inflation rising by x% because if it is still low there will be little real impact upon their standard of living – and they should see their salaries increasing by the level of inflation to retain their ‘real’ income and spending power.

While this is a very simplistic view of inflation it does offer a snap shot of how vital ‘controlled’ inflation is to any economy.

Negative impact of wild inflation

In general inflation which is out of control can and does lead to major problems for any economy as the value of the pound in your pocket and your spending power will reduce if your income is not able to keep pace with inflation. Taking the two examples above let us consider :-

Property Rental

When governments lose control of the rate of inflation this can have a massive impact upon many areas of the economy with property one of the main casualties. Let us say for example that inflation suddenly balloons to 10% which using the 10% rental yield example before would mean that a rental income of £10,000 a year would need to increase to £11,000 just to retain the ‘real’ value of the income stream. On a 10% rental yield this would indicate a value for the property of £110,000 but what happens if the tenants could only afford a 5% increase in the rent because their income had not increased in line with the higher than expected rate of inflation?

This would see the rent rise from £10,000 to £10,500 and indicate a value for the property of some £105,000 against the target of £110,000 to retain the ‘real’ value of the property after taking into account inflation – leaving a potential shortfall of some £5,000. Of course there are other implications for the property market as and when inflation picks up because the natural reaction by governments is to raise interest rates to reduce free money in the economy and bring prices back into line. However higher interest rates lead to higher mortgage costs which equates to less demand and falling property prices.

Implications for Business

The implications for business in general when in a period of high inflation can be crippling to say the least. Apart from the increase in interest rates and reduced money available for consumers and businesses to spend it can literally turn great businesses into wrecks in a very short space of time.

Let us assume the 10% rate of inflation above and the fact that suppliers have increased your costs by the rate of inflation as they know you need their product to run your business. Normally you would look to increase your prices by the rate of inflation to retain the ‘real’ value of your income. But what if the market (where consumers now have less money to spend) was not willing to accept a 10% price rise?

Assuming that you were able to push through ANY price rise, the difference between the increase in your charges and the increase in your costs is a burden the company would need to take on. In order to retain your level of profitability you would need to cut costs in some areas of the business – the more obvious area being the work force. If this situation is replicated across the UK economy then you would literally see thousands of people out of work and less and less free money for consumers to spend.

Reduced funds to spend would increase the competition for business, therefore reducing prices and increasing losses for many industries – an option many would take just to stay in business. In this scenario inflation has not only reduced the ‘real’ value of your income but also increased competition for business (as there is weakened consumer spending) which puts downward pressure on prices and prompts what can be a vicious circle.

Good, Bad and Ugly

Inflation is an evil which is good in small, controlled doses but can literally rip the heart out of an economy if left to its own devices. The general trend is for price, costs and income to increase at the same rate but it is a great skill to be able to balance all three in a controlled environment.

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