In-Depth Analysis of Currency Inflation: The Investment Key to Mastering Economic Cycles

Inflation is not just an economic concept; it is a key factor affecting your investment returns. A seasoned trader once said that a deep understanding of inflation mechanisms allowed him to profit over ten million in each trading cycle. In fact, inflation data directly influences the Federal Reserve’s policy decisions, which in turn impact global stock markets and capital flows in the crypto space.

Simply put, inflation is a phenomenon of currency devaluation: more money circulating in the market, rising prices of goods, and decreasing purchasing power. In layman’s terms, it means our “money is becoming less and less valuable.”

The Three Main Causes of Inflation

■ Cause 1: Excess Money Supply, Money Printing Out of Control

Imagine an island with only ten golden apples, and residents hold a total of 100 yuan in cash, with each apple worth ten yuan. Suddenly, the “central bank” on the island decides to print an additional 100 yuan, so now residents hold 200 yuan, but the number of apples remains the same. What happens? The price of apples doubles to twenty yuan each. This is a typical inflation caused by excessive money issuance.

In the real world, after the 2008 financial crisis, the Federal Reserve launched large-scale liquidity injections, leading to an oversupply of dollars worldwide. In recent years, to cope with pandemic shocks, governments have also massively pumped money into the economy, ultimately triggering a new wave of global inflation.

■ Cause 2: Commodity Shortages, Insufficient Supply

What if the money supply remains unchanged, but the supply of goods decreases? Prices will still rise. After the Russia-Ukraine conflict erupted in 2022, Russia cut off natural gas supplies to Europe, sharply increasing heating costs. Coupled with disrupted global supply chains during the pandemic, transportation difficulties made goods scarce, pushing prices higher. Energy, food, and raw material prices surged together, directly increasing living costs for consumers.

■ Cause 3: Rising Costs, Corporate Cost Pass-Through

When companies raise wages, operating costs increase accordingly. To maintain profits, businesses are forced to raise prices of goods and services, passing the costs onto consumers. Wage hikes eventually become a trigger for price increases.

Similarly, if raw material prices—such as chips, oil, or grains—rise, these costs cascade into consumer products, ultimately being paid by ordinary consumers.

Classification System of Inflation

Based on severity, inflation can be divided into three levels:

Mild Inflation (Benign)

This is the most ideal inflation state, usually maintained at an annual rate of 2%-3%, relatively stable and controllable. Economists generally believe that mild inflation can act like a lubricant to stimulate economic development. Slight price increases encourage businesses to invest and expand production, increase employment, and promote economic cycles. As long as inflation remains within 1%-2% to a maximum of 5%, its overall impact on society is limited.

Rapid Inflation (Dangerous)

This type of inflation exceeds mild levels, often reaching double digits, characterized by rapid, unstable, and accelerating deterioration. Market confidence in currency begins to waver, and the economy faces significant turmoil. Many historical crises started at this stage, making it a warning sign of considerable danger.

Hyperinflation (Deadly)

This is the most extreme scenario, with inflation rates often exceeding three digits, spiraling out of control. Currency rapidly depreciates in a short period, social financial systems fall into chaos, and normal economic order is destroyed. True hyperinflation is rare in history, usually occurring after wars or social upheavals.

Three Historical Hyperinflation Warnings

Germany 1923: The Complete Collapse of the Mark

Right after World War I, Germany was plunged into war reparations and economic chaos. Prices soared by 2,500% in just one month. The mark depreciated at an astonishing rate—one unit before the crisis was worth one trillionth of its pre-war value. At the worst point, factories had to pay wages twice a day because by afternoon, workers’ salaries had devalued to the point of being unable to buy that day’s food. The price of a loaf of bread fell from a house in the morning to an unmeasurable amount by evening.

Hungary 1946: Unprecedented Devaluation

After WWII, Hungary’s economy collapsed. The currency devalued even more severely than Germany’s, with one pengő worth only 10^-55 of its pre-war value (equivalent to 8^28 multiplied by 10^27 in scale). This number is so vast it defies description, reflecting the total breakdown of the economic system.

China 1937-1949: The End of the Legal Tender

From 1937 to 1949, China’s legal tender issuance increased by 1,445 billion times, while the price index rose by 36,807 billion times. In February 1948, a sack of rice cost three million yuan; just four months later in June, the price soared to ten million yuan, an increase of over three times. Prices kept accelerating, illustrating how terrifying this hyperinflation was. To cope with cash shortages, wages and goods had to be paid with bundles of banknotes.

Four Types of Inflation by Cause

Hidden Inflation

This inflation is concealed. There are inflationary pressures and potential price rises in the economy, but strict government price controls prevent inflation from erupting. Once controls are relaxed, hidden demand for inflation is unleashed, causing prices to surge.

Demand-Pull Inflation

When overall demand increases, the average prices of goods rise. For example, before holidays, ticket prices for flights and trains are often much higher than usual. The concentrated demand during peak seasons directly pushes up prices.

Cost-Push Inflation

Producers proactively raise prices due to rising costs, which cascade through the supply chain. When chicken prices rise, chicken burgers and sandwiches also increase in price; when oil prices go up, energy costs worldwide feel the pressure. Changes at the production end directly influence final prices.

Structural Inflation

In the absence of excessive overall demand, certain sectors experience excessive demand, leading to price increases in their products. During inflation periods, demand, costs, and structural factors often act together.

In summary, these four causes of inflation can be categorized as:

• Benign: Demand-pull
• To be cautious: Hidden and structural
• Dangerous: Cost-push
• Deadly: Out-of-control extreme

The Federal Reserve’s Rate Hike Strategy to Fight Inflation

In 2021, US inflation soared to its highest in nearly 40 years, with the Consumer Price Index (CPI) surpassing 9% at one point. Faced with runaway prices, the Fed was forced to adopt aggressive rate hikes.

How does raising interest rates curb inflation?

■ Raising rates increases borrowing costs: When interest rates rise, loans for businesses and individuals become more expensive, reducing investment and consumption. Effective demand in the market shrinks, easing upward price pressures.

■ Reducing market liquidity: Higher rates attract funds into savings and fixed-income investments, decreasing market liquidity as funds exit the market. Demand drops, helping stabilize prices.

However, rate hikes are not without costs. In 2023, persistent aggressive hikes caused bond yields to rise sharply, and bond values held by financial institutions plummeted. Silicon Valley Bank (SVB), holding large amounts of long-term low-interest bonds, faced huge losses and eventually declared bankruptcy. This shows that excessive rate hikes can trigger financial systemic risks, leading to bank failures and economic recession. There is a delicate balance between raising rates enough to control inflation and not so much as to damage the financial system.

The Four Impacts of Inflation

Living Standards Deteriorate, Purchasing Power Continues to Decline

Inflation drives up costs for rent, food, transportation, healthcare, and other essentials, but wages often lag behind. Ordinary workers see their real income decrease, savings shrink in value, and daily life becomes more difficult.

Savings Depreciate, Investment Becomes Difficult

Many people prefer to keep money in banks for safety, but this is a passive choice. When inflation hits 5% and bank fixed deposit rates are only 2%, your savings are effectively losing value—purchasing power drops by 3%. This is why more investors turn to real estate, stocks, and precious metals to preserve value.

Stagflation: Simultaneous Economic Stagnation and Inflation

The most frightening scenario is stagflation—economic growth stalls or contracts, yet inflation remains high. The US in the 1970s experienced this: slow growth, soaring unemployment, but persistent high prices. This “worst of both worlds” situation causes severe social damage.

Policy Dilemmas: Balancing Inflation and Employment

Central banks worldwide face a dilemma: raising interest rates to curb inflation can increase unemployment; maintaining low rates can protect jobs but risk runaway inflation. Finding the right balance has always been a core challenge of macroeconomic policy.

Inflation Indicators Investors Should Watch

Consumer Price Index (CPI)

CPI measures changes in the prices of goods and services purchased by ordinary consumers. Rapid CPI increases indicate rising living costs and eroding purchasing power. For investors, high CPI means cash assets are losing value faster, prompting the need for hedging strategies.

Producer Price Index (PPI)

PPI reflects cost changes at the production level. When PPI rises rapidly, these costs will eventually pass through to consumer prices, leading to higher CPI in the future. Monitoring PPI trends allows early prediction of inflation, giving investors time to adjust asset allocations.

Learning to interpret these two indicators can help investors proactively adjust their asset strategies and protect their wealth in an inflationary era.