Fundamentals of Investing - Episode 2 - Inflation and Role of Central Banks

In our last dive, we realized that money is just a Promise of Labor. It’s a token that says, “I did some work yesterday, so I should be able to get some bread today.” But if you’ve been to a grocery store lately, you’ve noticed those tokens don’t buy as much bread as they used to.Why? Because the government and Central Banks—the “Bank of Banks”—are constantly messing with the math. To understand our bank accounts, we have to understand the two most feared words in economics: Inflation and Deflation.1. The Bread Math: A Tale of Two MonthsImagine you’re standing in a bakery with a $100 bill.This month, that $100 buys you exactly 10 loaves of sourdough. You walk home happy. But you go back next month, lay that same $100 bill on the counter, and the baker tells you it only buys 9 loaves. The price went up, and your purchasing power—the actual “muscle” of your money—just dropped by 10%. This phenomenon is Inflation.Now, imagine the opposite. You go back, and the baker gives you 11 loaves for your $100. Your money got stronger. That’s Deflation. Simply put: Inflation is the speed at which things get expensive; Deflation is the speed at which they get cheaper.2. The Asset Gap: Who Wins the Inflation Game?Is inflation “good”? It depends on what you own.Think of inflation as a tide. If you own Assets—things like real estate, stocks, or gold—the tide lifts your boat. As the value of the dollar drops, the “price tag” on your house or gold bar naturally floats higher, increasing your net worth. It gives people an aspiration to grow and save.But for the person standing on the shore with no boat (no assets), that tide is a Nightmare. If you only have cash, you have to run faster and faster just to keep your head above water. This is why governments try to keep the cost of basics like food stable; they don’t want the tide to drown the most vulnerable.3. The Car Buyer’s Trap: Why Falling Prices Kill EconomiesIf things getting cheaper sounds like a dream, consider the $40,000 car.If you knew that car would cost $35,000 if you just waited six months, would you buy it today? Of course not. But if everyone thinks like you, the car dealership sells zero cars. They can’t pay their rent, so they fire the sales team. The manufacturer then stops making cars and fires the factory workers.Suddenly, no one has a paycheck, so they stop buying everything else. This is the Deflationary Spiral. The entire country comes to a screeching standstill. It’s like a massive engine freezing over in the winter—once it stops, it is incredibly hard to jump-start.4. The Remote Control: Central Banks and the “Repo Rate”To keep us from either burning up in inflation or freezing in deflation, we have a “Referee”—the Central Bank (like the Federal Reserve in the US or the RBI in India).Governments don’t get a steady paycheck; they rely on taxes. When they spend more than they earn, they have a Deficit and borrow from the Central Bank. The interest rate the government pays to borrow that money is called the Repo Rate.Why should you care? Because every loan in the world—your credit card, your home loan, or a business expansion loan—is priced a few percentage points above that Repo Rate.* When Inflation is high: The Central Bank turns the knob UP. Borrowing becomes expensive. Businesses spend less, people save more, and the “fire” of inflation cools down.* When Deflation looms: They turn the knob DOWN. They make money “cheap” so the government can spend on welfare and tax reliefs, hoping to “push-start” the engine. This is the dangerous part—you can’t force people to spend; you can only hope they do.THE HISTORICAL ANALOGY: The 1930s StandstillDuring the Great Depression, the world didn’t just suffer from poverty; it suffered from a lack of “flow.” Prices fell, so people hoarded cash under mattresses. Because no one spent, no one earned. It took a decade and a literal world war to get the engine turning again. This is why Central Banks fear deflation far more than inflation. You can put out a fire, but it’s much harder to revive something that has stopped breathing.THE BOTTOM LINEAs an investor, your job is to watch the Monetary Policy (the cycle of interest rates).* High Inflation + Rising Rates: Cash is actually quite valuable here. Why? Because as borrowing gets expensive, asset prices (like stocks) usually fall. This is when you use your cash to buy valuable assets at a discount.* High Inflation + Low Rates: The government is letting the fire burn. Holding pure cash is risky because its value is melting away.* Deflation: This is an economic “Black Swan.” These events are rare and chaotic—usually, the best move is to stay calm and wait for the government’s “jump-start” to take effect.Now that we know how the “system” manipulates the value of our labor, let’s look at what we should actually hold onto. In our next episode, we’ll dive into the difference between Real Assets and Liabilities.Disclaimer: I am not a financial advisor. This is for educational purposes only. Always do your own research and speak with a certified financial professional before making investment decisions.Thanks for reading! This post is public so feel free to share it.This Substack is reader-supported. To receive new posts and support my work, consider becoming a free or paid subscriber. Get full access to The Unlearned Investor at unlearnedinvestor.substack.com/subscribe