Understanding Inflation: How It Works, What's Hit Hardest, and What's Immune

The Strait of Hormuz has been closed for three months. The conflict in the Persian Gulf has cut off roughly a fifth of the world's seaborne oil and almost a third of its liquefied natural gas. Petrol prices are climbing on every continent. Food prices, transport prices, and energy bills are following — predictably, immediately, and globally.

Headlines are calling this "supply-side inflation." That framing is half right and entirely misleading. The supply shock is real. Calling the resulting price rises inflation confuses two different things and obscures who is actually responsible for the outcome.

This article works through what inflation actually is, how energy shocks transmit through the economy, why the Consumer Price Index systematically understates what households experience, and what — if anything — is immune to the mechanism. We use the current crisis as the entry point because it is the most visible recent example of a pattern that has been operating, more quietly, for fifty years.

Two Definitions of Inflation

There are two definitions of inflation in active use. The difference between them is not academic. It determines who you blame and what you think the solution is.

The mainstream definition

Inflation is a general rise in prices. Under this view, inflation is something that happens to prices. It can be caused by supply shocks (Hormuz), demand surges (post-COVID stimulus), wage spirals, or — vaguely — "expectations." The solution, in this framing, is for central banks to manage expectations and adjust interest rates, while supply-side issues are a separate matter for industrial and trade policy.

The classical definition

Inflation is an increase in the supply of money and credit. Under this view, inflation is something that happens to the currency. Rising prices are the consequence, not the cause. The solution is to stop expanding the money supply.

The Austrian School uses the classical definition. So did most economists before the mid-twentieth century. The shift to the mainstream definition was politically convenient: it relocates the cause from the central bank's actions to impersonal market forces. Other articles on this site explore this more fully.

Why Energy Shocks Look Like Inflation

Energy is the master commodity. Almost every other good and service in the modern economy embeds energy as a primary input. Fertiliser is energy. Plastic is energy. Shipping is energy. Aluminium is electricity. Bread is the diesel that powered the combine, the truck, the oven, and the delivery van.

When the price of energy rises, the price of almost everything else rises with it — sometimes lagged by weeks or months as inventories work through, but eventually and reliably. This is what is happening now. The Strait of Hormuz handles roughly 20–25% of global oil traffic. With that route closed since February, the world is operating on a smaller effective oil supply, and the price has adjusted upward accordingly.

So far this is just basic supply and demand: less of something is available, the price rises until enough demand is destroyed to clear the market. That is not inflation in the classical sense. That is a relative price shift — a change in what oil is worth relative to other goods and to money.

How a Supply Shock Becomes Real Inflation

Here is the part that financial journalism almost always misses. A pure supply shock — even a major one — does not, by itself, produce sustained inflation. It produces a one-off price level reset and a recession as households cut other spending to absorb higher energy costs. The economy contracts. Prices stabilise at the new level. People are poorer, but inflation does not become persistent.

Persistent inflation requires a second step: the central bank choosing to accommodate the shock by expanding the money supply. Faced with a recession caused by an external shock, central banks consistently choose monetary expansion over contraction. They cut interest rates. They expand their balance sheets. They monetise government deficits as fiscal authorities try to cushion the population from the shock with subsidies and stimulus.

That accommodation is the inflation. The shock is the trigger; the monetary response is the mechanism. Without the response, prices reset once and life goes on. With the response, prices keep rising — because the monetary expansion arrives in the economy after a 12–18 month lag, and once it does, every price denominated in the expanding currency drifts higher.

This is exactly what happened during COVID. The supply shock was a global lockdown. The monetary response was the fastest M2 money supply expansion in modern history — up roughly 40% in the United States within 18 months. Officials and journalists repeated for two years that there was "no inflation." They were looking at CPI, which lagged. By the time the inflation showed up in 2022, the cause had already happened. The mechanism was monetary, not viral.

Why CPI Lies (Politely)

The Consumer Price Index is the headline number in every official inflation report. It is also one of the most thoroughly manipulated statistics in modern economics. Not by conspiracy — by methodology. Each individual choice in how CPI is constructed is defensible in isolation. The aggregate effect is to systematically understate what households actually experience.

1. The basket changes

CPI tracks a basket of goods and services that is meant to represent what a typical household buys. The basket is updated periodically — items that have risen too much in price get reweighted down or substituted. If beef gets too expensive, the assumption is that consumers shift to chicken; the basket shifts toward chicken. The result: the index doesn't capture what beef actually costs to a household that still wants beef.

2. Hedonic adjustments

If a product gets better — more features, better quality, longer life — its price increase is statistically reduced to reflect the "quality improvement." A new car that costs 40% more than the equivalent car ten years ago might count as only a 10% inflation contribution because the new car has a backup camera, better fuel economy, and adaptive cruise control. The buyer still pays the full 40% more, but CPI sees only 10%.

3. Owner's equivalent rent

CPI does not measure house prices. It measures "owner's equivalent rent" — what a homeowner would pay to rent their own house, estimated through surveys. House prices have risen far faster than rents in most cycles. By using OER instead of actual purchase costs, CPI structurally undershoots housing's contribution to real cost-of-living pressure.

4. Asset prices excluded

CPI excludes assets entirely. Stocks, bonds, real estate as an investment, art, collectibles, gold. These are precisely where new money flows first under the Cantillon dynamic. By excluding them, CPI misses the most direct expression of monetary expansion.

The chart below makes the methodological problem visible. It shows the official CPI alongside the categories most households actually spend their incomes on.

CPI shows roughly 90% cumulative inflation since 2000. Housing in real terms has more than tripled. Healthcare has more than doubled. College tuition has nearly tripled. Energy, after a long period of relative stability, has resumed its upward path with the current crisis. None of these categories' real-world price trajectories are reflected accurately in the headline number.

What's Hit Hardest by Inflation

Inflation does not affect every asset class equally. Some forms of wealth are highly susceptible — they lose real value at roughly the rate the currency does. Others are partially insulated. A few are nearly immune. Understanding the differences is essential to making sensible decisions about how to hold what you have.

Highly susceptible: cash and fixed-income claims

Cash in a savings account is a direct claim on the future purchasing power of the currency. As that purchasing power erodes, the cash erodes with it. The interest paid on most savings accounts has, for most of the last fifteen years, been below the rate of true (non-CPI) inflation. The real return on cash savings has been negative, persistently.

The same applies to fixed-income bonds — including long-duration government bonds, which were the traditional "safe" allocation. A 30-year bond bought in 2020 at 1% yield has lost roughly 30% of its real purchasing power before adjusting for any duration risk. The bondholder receives the contracted nominal payments. Those nominal payments buy substantially less every year.

Highly susceptible: pensions

Defined-benefit pensions are promises to pay future fiat purchasing power. The fiat purchasing power gets debased; the promised payments cover progressively less of the recipient's real cost of living. Cost-of-living adjustments help only if they track real inflation rather than CPI — and most peg to CPI. Retirees on fixed-payment pensions are watching their standard of living erode in slow motion.

Susceptible: nominal wages without commensurate raises

Wages denominated in fiat are subject to the same erosion. If your nominal wage is flat and inflation runs at 4% per year, you have taken a 4% pay cut in real terms. Real wage growth requires nominal wage increases that exceed real inflation — which for most workers, in most years, has not happened.

Partially insulated: real estate

Property has functioned as an inflation hedge in the post-1971 era because it is a real asset and because of the leverage available to buy it. House prices in fiat terms tend to rise with the money supply over the long run. The disadvantages: properties are illiquid, expensive to maintain, geographically concentrated, taxed annually, and require leverage to acquire (which is itself a long-run bet on continued monetary expansion).

Partially insulated: equities

Shares of profitable companies tend to keep pace with inflation over long periods because the underlying businesses raise prices in line with their costs. The protection is imperfect — companies with high fixed costs and limited pricing power lose margin to inflation, while those with pricing power and asset-light models do better. Indices tend to track the money supply over decades, but with significant year-to-year volatility.

Mostly immune: gold

Gold has been the historical refuge from monetary debasement for thousands of years. Its supply expands at roughly 1.5% per year through mining — slower than fiat expands. Over very long periods, gold has held its purchasing power against everyday goods. Its limitations: poor portability for any meaningful quantity, high transaction costs for small amounts, no native yield, and (for most modern holders) custody complications.

Effectively immune: bitcoin

Bitcoin's supply is mathematically capped at 21 million coins. Its annual issuance halves every four years and approaches zero. It is, by every measurable property of monetary hardness, harder than gold. Unlike gold, it is perfectly portable, divisible to a hundred-millionth of a unit, and verifiable without trusted third parties. It has no income yield because it does not need one — it is money, not a productive asset.

To see what these differences mean in practice, the calculator below converts any past fiat amount to its current purchasing-power equivalent.

Run the math for cash held since 2000. The result is sobering. The result for any meaningful pension funded a generation ago is worse.

Where the Current Crisis Sits in This Framework

With the Hormuz situation and the energy shock it has produced, central banks globally face a familiar choice. They can let the supply shock translate into a sharp recession — high prices, demand destruction, economic contraction, eventual stabilisation at a new (lower) standard of living, no persistent inflation. Or they can accommodate by expanding money and credit, soften the recession in the short term, and import another wave of monetary inflation in 12–18 months.

The historical record is unambiguous about which choice they make. Every major energy shock since 1971 has been met with monetary accommodation: the OPEC shocks of the 1970s, the Gulf War spikes, the 2008 oil-and-financial-crisis combination, the post-COVID stimulus surge, and now this. The 1970s episode — the one that most resembles the current setup — produced over a decade of double-digit inflation and required Paul Volcker's late-1970s rate hikes to break it. Those hikes themselves caused a deep recession.

The mechanism is structural. Central banks cannot tolerate the deep recession that an unaccommodated supply shock produces. The political cost is too high. So they accommodate. The accommodation is invisible at first. The inflation arrives later. By the time it arrives, the cause has been forgotten, and the current set of price rises gets blamed on "new" supply shocks. The cycle continues.

This is what makes the current moment a teaching opportunity rather than a unique crisis. The pattern is the same. The mechanism is the same. The destination — a new round of monetary inflation that will be blamed on energy and supply chains rather than on the central banks that produced it — is the same.

The Same Shock, Priced in Bitcoin

If the same energy shock occurred in an economy operating on a Bitcoin standard, the dynamics would be different in one critical respect. The supply shock would still cause oil prices to rise in the short term. Demand for oil would fall as substitution and conservation kicked in. Some other prices would rise as energy costs cascaded through. Then prices would stabilise.

What would not happen: there would be no monetary accommodation, because there is no central authority that can expand the bitcoin supply. The shock would resolve through the market mechanisms that supply shocks are supposed to resolve through — substitution, demand destruction, alternative supply development. The recession would be sharper but shorter. There would be no second wave of monetary inflation 12–18 months later.

More importantly, in the long run, prices priced in bitcoin would resume their downward trajectory as productivity gains in the broader economy continued to compress costs. We have shown elsewhere that common goods priced in satoshis fall over time, because the bitcoin supply is fixed while the supply of goods rises. The current shock would be a small visible blip on a long downward trend rather than another step in a permanent upward staircase.

The chart above is the same items priced in satoshis over the last decade. The lines fall — sharply, on a log scale. This is what the cost of living looks like under sound money. Inflation, in the classical sense, does not exist there. Periodic shocks happen; the long-run direction of prices is downward.

The Global View

Inflation is not a national phenomenon. The post-1971 fiat experiment is global, and so is the inflation it produces. The current crisis affects every economy that uses fiat money — which is to say, every economy. The calculator below lets you see what your local currency has done in the last quarter century, against goods denominated in that currency.

Note the universality. Some currencies have lost more than others — but every single one has lost. There is no fiat currency in the world that has held its purchasing power across the last twenty-five years. This is not a national policy failure. It is the structural property of fiat money operating across all jurisdictions simultaneously.

Practical Conclusions

Once you can see inflation as a structural property of the monetary system rather than a series of unrelated supply shocks, your decisions about what to hold and how to plan change in specific ways.

• Cash and bonds are not safe. They are slow-motion losses. Hold the minimum cash you need for liquidity and operating expenses; do not save in cash.
• Pensions are unreliable promises. Where you have control, supplement them with hard-money savings. Where you don't, plan for receiving substantially less real value than the nominal promise suggests.
• Real estate and equities provide partial protection — at the cost of illiquidity, taxation, and the structural assumption that monetary expansion will continue forever.
• Gold has worked for thousands of years. It still works. Its limitations relative to bitcoin are real but it is a defensible store of value.
• Bitcoin is the only monetary asset whose supply cannot be debased. For anyone serious about preserving real purchasing power across decades, it is the structural answer.

None of this requires you to time markets, predict events, or speculate. It requires you to recognise the mechanism that has been producing the same outcomes for fifty years and to position yourself outside it where possible. The Bitcoin standard is the practical name for that position.

Closing: What Inflation Actually Is

Inflation is not the price of petrol going up. It is not the price of bread, of rent, of a coffee, of a flight, of a healthcare plan going up. Those are symptoms — the visible result of the mechanism, transmitted through whatever supply or demand channel happens to be active in any given quarter.

Inflation is the value of the currency going down. The energy crisis is real. The Hormuz closure is real. The cost pressure on households is real. None of it would be persistent without the monetary accommodation that follows every supply shock as reliably as night follows day.

The headlines will keep getting this wrong because the truth would implicate the issuers. The Bitcoiners who keep saying "fix the money" are saying it because the alternative is a permanent cycle of crisis, accommodation, and silent debasement, with the bill going to whoever is holding the soft money when the music stops.

The root problem with conventional currency is all the trust that's required to make it work. — Satoshi Nakamoto, 2009

Today's specific crisis is in the Persian Gulf. The next will be somewhere else. The mechanism that turns crises into inflation is not in the Persian Gulf. It is in the central banking system that converts every supply shock into a permanent monetary loss for the holders of the currency.

Holding bitcoin is not a bet on energy prices, on geopolitics, or on any specific macro thesis. It is a bet on the mathematics of a fixed supply against an unlimited one. Over any meaningful time horizon, that bet is not close.