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.
Is inflation protected in savings accounts?
There’s no guarantee that an online savings account or a high-yield reward checking account will keep up with inflation. The Series I Savings Bond, on the other hand, is a risk-free investment that is guaranteed to keep up with inflation (I bond).
When does inflation affect money in a savings account?
Interest on a savings account. Your purchasing power decreases as inflation rises. It will feel like you’re losing money if inflation outpaces the interest you earn on your bank account. Your account balance is rising, but not fast enough to keep up with rising prices.
How can I keep my investments safe from UK inflation?
Talib Sheikh, Multi-Head Asset’s of Strategy, explains why high inflation is harmful for investors and what they can do to protect their money’s purchasing power.
Inflation in the United Kingdom is at historic highs, and the Bank of England expects it to rise even more this spring. According to the most recent numbers, prices rose by 5.4 percent from December 2020 to December 2021, the highest increase in at least 30 years. This is exacerbated by record low interest rates, making the situation even more difficult for savers. Savings rates were frequently higher than inflation in the 1980s and 1990s, therefore cash savers made money in real terms. With interest rates sitting just near zero, savers are losing almost the whole inflation rate. To find something similar, you’ll have to travel back nearly 50 years. At current levels, even “safe” lower-risk investments like investment grade credit and government bonds are diminishing investors’ real spending power.
The real question is how long this will go on. ‘Transitory’, short-term bottlenecks connected with re-opening have received a lot of attention. Because we were in a post-pandemic phase of very low inflation this time last year, inflation appears to be high. It began to rise in spring 2021, thus the data will start to look less scary starting this spring.
Inflation in the United Kingdom, on the other hand, is expected to remain structurally higher than in the post-GFC period. The epidemic appears to have had long-term consequences on employment, bringing retirement and lifestyle changes forward, in addition to the loss of EU nationals following Brexit, which has resulted in higher salaries. For the foreseeable future, the Brexit transition will impose frictional costs on UK businesses. Furthermore, fiscal spending is expected to continue high: austerity in the aftermath of the 2008 financial crisis is no longer fashionable.
These factors contribute to the market’s forecast of a stunning 4% inflation rate for the UK over the next ten years. What about the savings rates on the other side of the equation? The ten-year interest rate in the United Kingdom has risen, although it is still only 1.5 percent. Andrew Bailey mentions raising interest rates to combat inflation, but he can only go so far. Over the last 10 years, UK homeowners have failed to lower debt levels, implying that the housing market remains a significant element of the UK economy. As a result, the UK is unable to accept interest rates that are significantly higher.
As a result, the problem of inflation eroding cash savings and low-risk investments isn’t going away anytime soon. At 4% inflation, a 100,000 cash investment earning 1% interest (which already assumes two more Bank of England rate hikes) loses a fifth of its real value in just ten years.
Investing is one strategy for people to protect themselves against inflation. While traditional assets such as high-quality credit offer low returns, equities, high-yield debt, emerging markets, and alternatives can provide significantly higher returns while also exposing investors to greater risk.
Investors in the United Kingdom who do nothing risk seeing their rainy-day accounts, retirement savings, and vacation funds decimated at the fastest rate in history by inflation. There are, however, other options for investors who want to be protected from inflation. When it comes to achieving the highest potential returns, investing in a multi-asset fund provides flexibility and a broader toolkit. This is accomplished by investing in higher-yielding, higher-risk asset classes while using diversification and active management to manage risk. As a result, even if the threat of inflation has never been higher, it is still conceivable to expand and protect capital in real terms, but it will require a different approach than in the past.
Who is harmed by inflation?
According to a new Gallup poll, nearly half of Americans think rising costs have created difficulty for their families, with lower-income Americans “suffering the most.”
Inflation has increased by 7% year over year, a pace that is felt most keenly by those with lower earnings.
Gallup found that two-thirds of lower-income adults those earning less than $40,000 per year have suffered moderate to severe difficulty as a result of increased prices.
Meanwhile, 56 percent of middle-income Americans (those earning $40,000 to $99,000 per year) and 32 percent of upper-income Americans (those earning $100,000 or more) stated they are going through at least moderate hardship.
Gallup also discovered that nearly eight out of ten Americans expect inflation to grow, which is more than typical. (Gallup found that 6 out of 10 Americans expected inflation to rise between 2007 and 2020.)
The findings are similar to those of projects like the Penn Wharton Budget Model, which recently published a report on the impact of inflation on household income. Lower-income households spent around 7% more on goods and services in 2021 than they did in 2019 and 2020, while higher-income households spent roughly 6% more.
The Federal Reserve said Wednesday that it may raise interest rates in March in response to growing inflation; this would be the first time rates have risen in three years.
Is cash a smart investment amid inflation?
According to Arnott, cash is frequently neglected as an inflation buffer. “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.
Why are savings accounts failing to keep pace with inflation?
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.
To stay up with inflation, what APY do I need?
Inflation is currently at 1.6 percent, according to a widely accepted metric. Meanwhile, the average yearly percentage interest on national savings is merely 0.1 percent (APY).
This indicates that if your money earns less than 1.6 percent annual percentage yield, you’re losing purchasing power.
Savings, money market account, and CD rates have all lately reduced. However, certain high-yield savings accounts are still keeping up with inflation despite nine Fed rate hikes since 2015 and only one rate cut in July. If the Fed meets again on September 17-18, another rate cut could make keeping up with inflation a little more difficult.
Inflation favours whom?
- 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.