Inflation is an economy-wide, sustained trend of increasing prices from one year to the next. The rate of inflation represents how quickly investments lose their real value and how quickly prices increase over time. Inflation also tells investors exactly how much of a return (in percentage terms) their investments need to make for them to maintain their standard of living.
Key Takeaways
- The rate of inflation represents how quickly investments lose their real value and how quickly prices increase over time.
- Inflation also indicates how much of a return investments need to make to maintain a specific standard of living.
- Inflation occurs when the supply of money increases relative to the level of productive output in the economy.
- A rise in the price of only one product is not in itself inflation, but may just be a relative price change reflecting changes in supply or demand.
Understanding Inflation
The easiest way to illustrate inflation is through an example. Suppose you can buy a burger for $2 this year and the yearly inflation rate is 10%. Theoretically, 10% inflation means that next year the same burger will cost 10% more, or $2.20.
So, if your income doesn't increase by at least the same rate of inflation, you will not be able to buy as many burgers; however, a one-time jump in the price level caused by a jump in the price of oil or the introduction of a new sales tax is not true inflation, unless it causes wages and other costs to increase into a wage-price spiral.
Likewise, a rise in the price of only one product is not in itself inflation, but may just be a relative price change reflecting a decrease in supply for that product. Inflation is ultimately about money growth, and it is a reflection of too much money chasing too few products.
2%
The target inflation rate by the Federal Reserve.
Inflation occurs when the supply of money increases relative to the level of productive output in the economy. Prices tend to rise because more dollars are chasing relatively fewer goods. Another way of stating this phenomenon is that the purchasing power of each money unit declines.
With this idea in mind, investors should try to buy investment products with returns that are equal to or greater than inflation. For example, if ABC stock returned 4% and inflation was 5%, then the real return on investment would be minus 1% (5% - 4%).
Inflation and Asset Classes
Inflation has the same effect on liquid assets as any other type of asset, except that liquid assets tend to appreciate more slowly. This means that liquid assets are more vulnerable to the negative impact of inflation. In terms of the broader economy, higher rates of inflation tend to cause individuals and businesses to hold fewer liquid assets.
Illiquid assets are also affected by inflation, but they have a natural defense if they appreciate in value or generate interest. One of the chief reasons most workers place money into stocks, bonds, and mutual funds is to keep their savings safe from the effects of inflation. When inflation is high enough, individuals often convert their liquid assets into interest-paying assets, or they spend the liquid assets on consumer goods.
So, you can protect your purchasing power and investment returns (over the long run) by investing in a number of inflation-protected securities such as inflation-indexed bonds or Treasury inflation-protected securities (TIPS). These types of investments move with inflation and therefore are immune to inflation risk.
What Causes Inflation?
The primary cause for inflation is when the demand for a good or service is greater than the available goods or services. This is known as demand-pull inflation and leads to a price increase. Inflation is also a result of the increase in the production costs of goods and services. As the costs of producing a good increases, producers increase the sales price to generate or maintain a certain profit. This is known as cost-pull inflation.
How Do Governments Keep Inflation Down?
Governments have a few tools to keep inflation low. They can implement wage and price controls, however, that goes against the nature of free markets and can lead to job losses and a recession. On the other hand, central banks can implement monetary policy measures to combat rising inflation by making it more expensive to borrow money.
Does Inflation Favor Lenders or Borrowers?
Inflation can help both lenders and borrowers. Inflation benefits a borrower if they owed money before inflation occurred. This has to be in conjunction with a wage increase, however. Inflation can also help lenders as the interest rate they charge on financing equates to a higher dollar value because prices have gone up.
The Bottom Line
Inflation refers to the general trend of an increase in prices over a certain period of time. As inflation occurs, purchasing power decreases, meaning that it costs more to buy the same good or service, or that the same amount of money buys fewer goods and services.
For investors, returns on investments should be at least as high as the inflation rate. Otherwise, their investments are losing money even if they gain in dollar value. Similarly, individuals should ensure that their salaries keep pace with inflation; otherwise, they are losing buying power.
FAQs
Inflation is when overall prices increase, reducing the purchasing power of money over time. Inflation can erode the value of savings, especially those with a fixed payout that may not keep pace with rising prices.
What is inflation and how does it affect investments? ›
The rate of inflation represents how quickly investments lose their real value and how quickly prices increase over time. Inflation also tells investors exactly how much of a return (in percentage terms) their investments need to make for them to maintain their standard of living.
What are the worst investments during inflation? ›
What Are the Worst Things to Invest in During Inflation? Some of the worst investments during high inflation are retail, technology, and durable goods because spending in these areas tends to drop.
How does inflation affect savings accounts and investments? ›
Inflation impacts your savings by reducing the value of your money over time. Many high-yield savings accounts and CDs are now beating inflation with high interest rates. High savings account interest rates won't last forever and will start dropping once the Federal Reserve cuts rates.
How does inflation affect fixed income investments? ›
Fixed-income assets are debt instruments with regular cash flows, paying coupons and principal. All else remaining equal, as the prices of goods and services rise, the same fixed coupon payment can buy less of them than the previous one. Rising inflation therefore erodes the real value of fixed nominal cash flows.
Should you invest in stocks when inflation is high? ›
Rising inflation can be costly for consumers, stocks and the economy. Value stocks perform better in high inflation periods and growth stocks perform better when inflation is low. Stocks tend to be more volatile when inflation is elevated.
Is inflation good or bad for investors? ›
Inflation can significantly reduce real returns on fixed income investments such as corporate or municipal bonds, treasuries, and CDs. Typically, investors buy fixed income securities because they want a stable income stream in the form of interest payments.
What is the best investment to keep up with inflation? ›
6 Inflation Investments for the Future
- Equities. Equities generally offer a reliable haven during inflationary times. ...
- Real Estate. Real estate is another tried-and-true inflationary hedge. ...
- Commodities (Non-Gold) ...
- Treasury Inflation-Protected Securities (TIPS) ...
- Savings Bonds. ...
- Gold.
With any diversified portfolio, keeping inflation-hedged asset classes on your watch list, and then striking when you see inflation can help your portfolio thrive when inflation hits. Common anti-inflation assets include gold, commodities, various real estate investments, and TIPS.
Why is high inflation bad for investors? ›
Additionally, all companies are seeing their costs rise. Inflation also impacts the price of materials they require for producing the products they sell. Since their costs are going up, profits can fall, which is something else that lowers the stock price.
5 Ways to Hedge Against Inflation
- Move Your Money into a High-Yield Savings Account. If you have your money stashed in a checking or basic savings account—or worse, at home—inflation erodes the value over time. ...
- Buy Treasury Bonds. ...
- Invest in the Stock Market. ...
- Diversify Your Portfolio. ...
- Explore Alternative Investments.
Inflation allows borrowers to pay lenders back with money worth less than when it was originally borrowed, which benefits borrowers. When inflation causes higher prices, the demand for credit increases, raising interest rates, which benefits lenders.
Are savings accounts safe from inflation? ›
But there's good news for savers: Since March 2023, the top savings yield is outpacing inflation, according to Bankrate data. The current savings rate environment features many top savings account annual percentage yields (APYs) actually outpacing 3.5 percent inflation.
Are bonds good during inflation? ›
Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a bond's future cash flows. Typically, bonds are fixed-rate investments. If inflation is increasing (or rising prices), the return on a bond is reduced in real terms, meaning adjusted for inflation.
Should you sell bonds when interest rates rise? ›
Unless you are set on holding your bonds until maturity despite the upcoming availability of more lucrative options, a looming interest rate hike should be a clear sell signal.
Can fixed deposit beat inflation? ›
Renew FD account - To beat inflation and maximise your FD returns opt for short-term deposits and keep renewing it to earn maximum returns after every renewal. This also enables you to benefit from the revised interest rate and keeps you away from market fluctuations.
Why does inflation matter for investors? ›
Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programs, tax policies, and interest rates. Understanding inflation is crucial to investing because inflation can reduce the value of investment returns.
What happens to money when inflation is high? ›
As prices increase, purchasing power (or the value of currency) consequently decreases. And when inflation “surges,” it means that each unit of currency today is worth less than it was just a few months ago. Even if you make zero changes to your lifestyle or everyday purchases, the amount you spend will be higher.
Why are people with savings hurt by inflation? ›
“Since inflation erodes their money's purchasing power, all the money they've saved for years can suddenly buy less than it could a year ago.” To protect your retirement savings from inflation, Benson suggests working with a financial advisor who can ensure you're invested in a well-diversified portfolio.
