Nov 24 2010

Could QE2 and Inflation Be Good For Consumers?

All this news of QE2 (second phase of quantitative easing) from the Federal Reserve has been saturating the media – and it rightly deserves that spotlight. It is yet another desperate move to resuscitate the troubling economy. And, the intended outcome is inflation.

For a long time, we have talked about how inflation eats away at our spending power and our investment returns. We try to keep up with, and ideally beat, inflation with high-yield savings accounts and riskier investments. Generally, we are not fond of it and see it as a negative economic phenomenon. But, inflation, especially at this point in time, can be a financial tool for typical consumers such as you and I.

How QE2 Tries to Spur Inflation

The Fed’s decision to implement QE2 involves creating money out of thin air – to the amount of $600 billion, which will be injected into the U.S. financial system over the course of six months.

So, in half a year, our money will be worth less than it is today. As a result, retailers will be raising prices on goods and services. Meanwhile, our incomes will most likely not increase to reflect the inflationary changes.

Understanding “Printing Money”

Imagine a nation had a piece of gold currently worth $100 and it backed one hundred $1 bills in circulation. So, $1 represents 1% of that piece of gold.

Should this nation implement quantitative easing by “printing” one hundred more $1 bills, there would be $200 in circulation – but the amount of gold owned by the nation remained the same.

Effectively, a $1 bill equates to 0.5% of that piece of gold. For people who had money prior to quantitative easing, their money lost 50% of its value.

Why Inflation Doesn’t Totally Suck

Inflation can be beneficial to people with debt, which probably includes almost every American adult.

With time, the economic environment will follow inflation (i.e. higher investment returns, savings accounts yields, and income).

The ideal beneficiary of inflation is the consumer who is carrying a large amount of long-term debt with fixed rates such as student loans and mortgages. Let’s say you took out a 30-year $100,000 mortgage loan 20 years ago to buy a home. That $100,000 could buy much more house back then compared to now – yet, you are still paying it off with today’s inflated currency.

Businesses can change prices according to the effects of inflation but the balance on a debt cannot increase according to inflation. Therefore, inflation will devalue your debt.

Please don’t mistake this as advice to rack up debt now. Quantitative easing doesn’t offer any guarantees. If inflation does result, it will not make a big difference in the short term future because it takes quite a long time to have a significant effect on the individual consumer. Your surmounting credit card debt will suffer little devaluation (you should be more worried about interest charges).

(Photo credit: Packmatt)

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2 Comments on this post

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  1. Financial Samurai said:

    I’m really looking forward to real assets inflating and my debt getting inflated away. Moderate inflation rocks! Just need to buy some real assets!

    November 25th, 2010 at 12:33 pm
  2. Bret @ Hope to Prosper said:

    Right now, the true rate of inflation is probably around 4%, which is a healthy amount. Pushing inflation toward double digits will have major negative consequences, since real wages and fixed incomes won’t keep pace. This may help debtors, like our government, but it certainly won’t help most Americans. We had high inflation in the ’70s and it was a disaster.

    Inflation is just a way for the government to steal from everyone who owns a dollar or a government bond.

    November 28th, 2010 at 5:32 pm

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