Most individuals are aware that inflation raises the cost of their food and depreciates the worth of their money. In reality, inflation impacts every aspect of the economy, and it can eat into your investment returns over time.
What is inflation?
Inflation is the gradual increase in the average cost of goods and services. The Bureau of Labor Statistics, which compiles data to construct the Consumer Price Index, measures it (CPI). The CPI measures the general rise in the price of consumer goods and services by tracking the cost of products such as fuel, food, clothing, and automobiles over time.
The cost of living, as measured by the CPI, increased by 7% in 2021.
1 This translates to a 7% year-over-year increase in prices. This means that a car that costs $20,000 in 2020 will cost $21,400 in 2021.
Inflation is heavily influenced by supply and demand. When demand for a good or service increases, and supply for that same good or service decreases, prices tend to rise. Many factors influence supply and demand on a national and worldwide level, including the cost of commodities and labor, income and goods taxes, and loan availability.
According to Rob Haworth, investment strategy director at U.S. Bank, “we’re currently seeing challenges in the supply chain of various items as a result of pandemic-related economic shutdowns.” This has resulted in pricing imbalances and increased prices. For example, due to a lack of microchips, the supply of new cars has decreased dramatically during the last year. As a result, demand for old cars is increasing. Both new and used car prices have risen as a result of these reasons.
Read a more in-depth study of the present economic environment’s impact on inflation from U.S. Bank investment strategists.
Indicators of rising inflation
There are three factors that can cause inflation, which is commonly referred to as reflation.
- Monetary policies of the Federal Reserve (Fed), including interest rates. The Fed has pledged to maintain interest rates low for the time being. This may encourage low-cost borrowing, resulting in increased economic activity and demand for goods and services.
- Oil prices, in particular, have been rising. Oil demand is intimately linked to economic activity because it is required for the production and transportation of goods. Oil prices have climbed in recent months, owing to increased economic activity and demand, as well as tighter supply. Future oil price rises are anticipated to be moderated as producer supply recovers to meet expanding demand.
- Reduced reliance on imported goods and services is known as regionalization. The pursuit of the lowest-cost manufacturer has been the driving force behind the outsourcing of manufacturing during the last decade. As companies return to the United States, the cost of manufacturing, including commodities and labor, is expected to rise, resulting in inflation.
Future results will be influenced by the economic recovery and rising inflation across asset classes. Investors should think about how it might affect their investment strategies, says Haworth.
How can inflation affect investments?
When inflation rises, assets with fixed, long-term cash flows perform poorly because the purchasing value of those future cash payments decreases over time. Commodities and assets with changeable cash flows, such as property rental income, on the other hand, tend to fare better as inflation rises.
Even if you put your money in a savings account with a low interest rate, inflation can eat away at your savings.
In theory, your earnings should stay up with inflation while you’re working. Inflation reduces your purchasing power when you’re living off your savings, such as in retirement. In order to ensure that you have enough assets to endure throughout your retirement years, you must consider inflation into your retirement funds.
Fixed income instruments, such as bonds, treasuries, and CDs, are typically purchased by investors who want a steady stream of income in the form of interest payments. However, because most fixed income assets have the same interest rate until maturity, the buying power of interest payments decreases as inflation rises. As a result, as inflation rises, bond prices tend to fall.
The fact that most bonds pay fixed interest, or coupon payments, is one explanation. Inflation reduces the present value of a bond’s future fixed cash payments by eroding the buying power of its future (fixed) coupon income. Accelerating inflation is considerably more damaging to longer-term bonds, due to the cumulative effect of decreasing buying power for future cash flows.
Riskier high yield bonds often produce greater earnings, and hence have a larger buffer than their investment grade equivalents when inflation rises, says Haworth.
Stocks have outperformed inflation over the previous 30 years, according to a study conducted by the US Bank Asset Management Group.
2 Revenues and earnings should, in theory, increase at the same rate as inflation. This means your stock’s price should rise in lockstep with consumer and producer goods prices.
In the past 30 years, when inflation has accelerated, U.S. stocks have tended to climb in price, though the association has not been very strong.
Larger corporations have a stronger association with inflation than mid-sized corporations, while mid-sized corporations have a stronger relationship with inflation than smaller corporations. When inflation rose, foreign stocks in developed nations tended to fall in value, while developing market stocks had an even larger negative link.
In somewhat rising inflation conditions, larger U.S. corporate equities may bring some benefit, says Haworth. However, in more robust inflation settings, they are not the most successful investment tool.
According to a study conducted by the US Bank Asset Management Group, real assets such as commodities and real estate have a positive link with inflation.
Commodities have shown to be a dependable approach to hedge against rising inflation in the past. Inflation is calculated by following the prices of goods and services that frequently contain commodities, as well as products that are closely tied to commodities. Oil and other energy-related commodities have a particularly strong link to inflation (see above). When inflation accelerates, industrial and precious metals prices tend to rise as well.
Commodities, on the other hand, have significant disadvantages, argues Haworth. They are more volatile than other asset types, provide no income, and have historically underperformed stocks and bonds over longer periods of time.
As it comes to real estate, when the price of products and services rises, property owners can typically increase rent payments, which can lead to increased profits and investor payouts.
What impact does inflation have on savers?
Because prices are expected to rise in the future, inflation might erode the value of your investments over time. This is particularly obvious when dealing with money. If you keep $10,000 beneath your mattress, it may not be enough to buy as much in 20 years. While you haven’t actually lost money, inflation has eroded your purchasing power, resulting in a lower net worth.
You can earn interest by keeping your money in the bank, which helps to offset the effects of inflation. Banks often pay higher interest rates when inflation is strong. However, your savings may not grow quickly enough to compensate for the inflation loss.
What impact does inflation have on savings and borrowers?
- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
Is rising inflation beneficial to savers?
Due to historically low interest rates, money saved in savings accounts hasn’t increased much in recent years. However, with significant inflation, your savings may lose value in’real’ terms, as you will be able to buy less with your money.
Assume that inflation will average 3% over the next five years. That indicates that a 1,000 purchase today will cost 1,159.27 in 2026.
If you put 1,000 in a savings account today that pays 0.5 percent interest, you’ll only get 25.25 back in a year. As a result, you’d lose 134.02 in total.
How can I keep my investments safe from UK inflation?
Inflation may have dropped in recent months, but savers still have a fight on their hands if they wish to avoid its corrosive effects.
We’ll look at how taking certain risks with your money can help you keep your money’s value above inflation.
Shift longer term savings into equities
You might have some money in a savings account. After all, it’s recommended that you save away roughly six months’ worth of earnings as an emergency fund. However, you may discover that you have more than you require. If that’s the case, think about putting some of it into investments that have a better chance of long-term growth.
Equities have historically been the most successful assets for fighting inflation over the long term but you must be comfortable with your investments rising and falling in value.
Choose your investments wisely
Other investments, if you know where to search, can produce returns that are higher than inflation. Bond funds, for example, could be included in a portfolio of investments because they invest in debt issued by governments and/or enterprises seeking to raise financing. Throughout their lives, bonds pay a defined rate of interest, known as the coupon, and should refund the original capital at maturity. To spread risk, bond funds invest in a variety of debt instruments.
A financial adviser can help you create a portfolio that takes advantage of all available investment opportunities.
Maximise tax efficiency
After you’ve figured out how to fight inflation, think about how tax-efficient your assets are. ISAs and pensions are both tax-advantaged vehicles for saving and investing for the long term.
ISAs allow you to save up to 20,000 a year in tax-free growth and income on investments, as well as tax-free withdrawals. Meanwhile, depending on your taxable income, pension payments may be eligible for income tax relief of up to 45 percent.
When you can afford it and while they’re still accessible, it’s a good idea to take advantage of hefty tax breaks over time. This way, you may take advantage of compound growth or earning returns on your returns to help you keep up with inflation.
Seek expert advice
A sound investment strategy should include a diverse portfolio of assets and the use of tax-advantaged investment vehicles.
We can put together a diversified portfolio that is geared to your long-term financial goals, risk tolerance, and inflation protection. Get in contact with us right now to learn more.
Is mortgage interest affected by inflation?
Inflation is what really matters when it comes to mortgage pricing (independent of where the Bank sets base rates). Higher inflation basically means higher mortgage interest rates.
What impact does inflation have on investments?
Savings are enticed by high interest rates. Is it true that Indian depositors are wealthier than those in the United States and Europe as a result of this? Does this imply that Indian banks reward their depositors more? However, in actuality, this is not the correct picture. Over the previous three years, nominal interest rates (the rate you earn when you invest in a bank deposit or a debenture) have risen. However, they haven’t moved much in real terms (adjusted for inflation).
Inflation is defined as a prolonged increase in the price of goods and services, resulting in a decrease in people’s purchasing power. The value of money depreciates over time due to inflation. This means that the value of Rs. 1,00,000 in your bank account would depreciate in the future. In 30 years, assuming a 7% annual inflation rate, the value will have decreased by 86.86 percent. As a result, the returns on our investments will be lower. While we may believe we have received remarkable returns, when inflation is factored in, most investments, such as fixed income and gold, rarely generate wealth. The difference between nominal and real returns is known as real return. Inflation is the consumer’s worst adversary since it erodes pricing power. Consumers suffer more from inflation than savers. The nominal rate of return attracts most investors, who ignore the real rate of return. Inflation stealthily eats away at their money.
What effect does inflation have on personal wealth?
Take out your wallet and pull out the PhP 50 bill. If you look at it closely, you’ll notice a sense of nostalgia. This bill is not the same as the one you had a decade ago. It definitely looks different, and the one you’re holding now isn’t worth the same as the PhP 50 you had back then, which was enough to get you a lunch at your favorite fast food joint.
Nowadays, your PhP 50 will only get you a little dinner, and how you wish you could travel back in time to when receiving PhP 50 from your parents was still exciting.
You may have figured out what causes the value of your money to depreciate. It’s a phenomenon known as inflation. Inflation, to refresh your mind, is the general increase in the prices of products and services over time, such as common foods, household goods, medical services, and transportation.
So, how does inflation affect your personal money, other from not allowing you to eat a lunch for PhP 50?
The rate of inflation fluctuates on a regular basis, and we rely on official data from the Philippine Statistics Authority, or Bangko Sentral ng Pilipinas, to establish how fast or slow it is. Between 1957 and 2011, the Philippines’ average inflation rate was 9.28 percent. 1
Let’s look at the cost of products and services in 2017 and 2018 to see how much inflation has affected your purchasing power. You’ll find that you have to pay much more for the identical stuff in only a year.
Assume a grocery bag including bread, fish, grains, meat, veggies, and fruits costing PhP 600 in 2017 costs PhP 631.2 in 2018. Similarly, if you paid PhP 500 in 2017 for water, electricity, and gas, the same services will cost PhP 526 in 2018. Other products, such as alcoholic beverages and tobacco, have witnessed comparable price increases. 2
When the cost of goods and services exceeds the amount of money you make, problems occur. Your purchasing power, or capacity to buy, decreases as a result. To keep up with the rising cost of living, inflation may require you to forego indulgences and “tighten your belt.” Small increases in spending can diminish your disposable income and, over time, erode the value of your savings.
Savings and investments do not always imply that your money is growing, particularly if the interest rate is lower than the rate of inflation. In fact, you could be squandering your hard-earned cash.
For example, if a business owner holds PhP 100,000 in a time deposit bank account earning 1% interest, the money will grow to PhP 101,000 the next year. If the inflation rate is 4.4 percent 3, the value of his/her money will only be PhP 96600the PhP 1,000 you acquired will not be enough to compensate for the PhP 4,400 worth lost due to inflation.
How does inflation effect your savings?
Savings (money set aside for future use) lose purchasing power as a result of inflation since the ability to buy products with the money saved decreases.
During inflation, where should I store my money?
“While cash isn’t a growth asset, it will typically stay up with inflation in nominal terms if inflation is accompanied by rising short-term interest rates,” she continues.
CFP and founder of Dare to Dream Financial Planning Anna N’Jie-Konte agrees. With the epidemic demonstrating how volatile the economy can be, N’Jie-Konte advises maintaining some money in a high-yield savings account, money market account, or CD at all times.
“Having too much wealth is an underappreciated risk to one’s financial well-being,” she adds. N’Jie-Konte advises single-income households to lay up six to nine months of cash, and two-income households to set aside six months of cash.
Lassus recommends that you keep your short-term CDs until we have a better idea of what longer-term inflation might look like.