What Exactly Is Inflation Anyway? 

Most of the time inflation occurs when an economy is growing at a very rapid rate. 

During economic good times you hear a lot about wage inflation. This happens when the demand for workers becomes so great that companies have to hike wages in order to attract more talent. As more workers receive more money, they buy more stuff. This buying can lead then lead to higher prices for goods and services as greater demand pushes prices higher. The net effect of all of this is that the purchasing power of the country's dollars declines.

But we're not experiencing strong economic growth… so how could inflation become an issue now?

Now, more than ever, we live in a globally linked economy. With the industrialization of China and India there is now a new demand for raw materials that has never existed before. As those countries' economies grow and their populations get richer, they will seek to buy more "stuff," and that buying could lead to higher prices, aka inflation.

The other inflation specter out there is the U.S. dollar. Because most commodities are priced in U.S. dollars (regardless of where you live most commodities are quoted, bought and sold in American dollars), as the dollar weakens commodity prices rise to account for the dollar's weakness.

The reason is that, as the dollar goes down, other currencies are strengthening against the dollar which means that foreigners can buy more dollars for their rubles, pounds, Yen what have you. This means that they can buy more dollar-denominated commodities using less of their home currency.

The Dollar's Impact on Commodity Prices

To show you how important U.S. dollar stability is to commodity prices, check out the action in oil.  From 2002 until 2008 the U.S. dollar index declined approximately 50%. As the dollar went down, crude oil prices went from $20 a barrel to $147 a barrel. A 50% drop in the value of the dollar led to a 600% increase in the price of oil!

Here is the flip side: spot oil prices peaked at $147 in July of 2008 just as the U.S. dollar was bottoming.  The U.S. dollar index then rallied 25% and we saw crude oil prices drop an astounding 76% to $36 a barrel!

As we can clearly see, the strength or weakness of the U.S. dollar has a huge impact on how much we pay for oil as well as all of the other dollar-denominated commodities.

If the dollar goes into freefall, U.S. consumers will get hammered by sky-rocketing commodity prices; that's your oil, your sugar, wheat, corn, metals… everything we buy and use will go up in price.  The worst part of this is that we could see big price hikes and no compensating economic growth.

This is the "earn less but pay more for everything" economy that many folks dealt with in the 1970s. 

The good news is that there are certain steps you can take to help insulate yourself from a potential inflation shock, especially one created by a cratering U.S. dollar.

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