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 is the impact of inflation on the stock market?
Investors attempt to predict the elements that influence portfolio performance and make decisions based on their predictions. One of the issues that can affect a portfolio is inflation. Stocks should, in theory, provide some inflation protection since, after a time of adjustment, a company’s revenues and earnings should grow with inflation. Inflation’s variable impact on equities, on the other hand, tends to raise equity market volatility and risk premium. In the past, high inflation has been linked to lower equity returns.
What is the significance of inflation to investors?
Consumer spending, company investment, and employment rates are all affected by inflation, as are government programs, tax policies, and interest rates. In order to invest successfully, you must first understand inflation. Inflation can diminish the value of your investment returns.
Is inflation harmful to investors?
- When the rate of inflation outpaces the rate of interest generated on a savings or checking account, the investor loses money.
- In the United States, the Consumer Price Index (CPI) is the most widely used method of calculating inflation.
- Many people argue that indexing Social Security payments to the Consumer Price Index (CPI) is insufficient.
- Investing in Treasury Inflation-Protected Securities (TIPS), government I bonds, stocks, and precious metals can help preserve investments from inflation.
Is investing risky when inflation is high?
“Investors should continue to keep equities since stocks normally outperform in times of inflation, especially if it is accompanied by growth.” Consumer staples stocks, such as food and energy, perform well during inflation because demand for staples is inelastic, giving these companies more pricing power because they can increase their prices more quickly than other industries.”
Opt for stocks and TIPs, says Leanne Devinney, vice president of Fidelity Investments
“Diversifying between different sorts of investments is a solid idea.” For example, equities, rather than bonds, have a better track record of keeping up with inflation over time. Consider Treasury Inflation-Protected Securities (TIPS) and high-yield bonds, which are both inflation-resistant fixed income investments. It may also assist in reducing exposure to more inflation-sensitive investments, such as some treasury bonds.”
Change up how you deal with your cash, says Pamela Chen, chartered financial analyst at Refresh Investments
“When there is a rise in inflation, it is more vital to invest funds. During inflationary periods, when prices for things rise, cash loses purchasing power, and one dollar buys less than it used to. Invest your money to generate a return that will help you avoid the inflationary bite, or to achieve a return that will stay up with or exceed inflation.”
What is creating 2021 inflation?
As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.
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.
What Does Inflation Mean for Traders?
Inflation is a long-term pattern of rising prices across the economy from one year to the next. The rate of inflation is an essential economic topic because it shows the rate at which an investment’s real worth erodes and the loss of spending or purchasing power over time. Inflation also shows investors how much of a return on their assets they need to maintain their level of life (in percentage terms).
What is the impact of inflation on financial planning?
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 effect does inflation have on fixed-income investments?
When interest rates rise, inflation can have a negative impact on fixed-income assets. Inflation objectives are usually set by central banks, such as the Federal Reserve of the United States. Officials will raise interest rates if inflation begins to exceed the acceptable level. Existing fixed-income assets’ interest payments are becoming less competitive in comparison to newer higher-rate fixed-income instruments, hence their prices are often falling. In other words, interest rates and fixed-income asset prices have an inverse connection. Inflationary pressures can also wreak havoc on tactics that rely on fixed payments.
Who does inflation harm?
Inflation is defined as a steady increase in the price level. Inflation means that money loses its purchasing power and can buy fewer products than before.
- Inflation will assist people with huge debts, making it simpler to repay their debts as prices rise.
Losers from inflation
Savers. Historically, savers have lost money due to inflation. When prices rise, money loses its worth, and savings lose their true value. People who had saved their entire lives, for example, could have the value of their savings wiped out during periods of hyperinflation since their savings became effectively useless at higher prices.
Inflation and Savings
This graph depicts a US Dollar’s purchasing power. The worth of a dollar decreases during periods of increased inflation, such as 1945-46 and the mid-1970s. Between 1940 and 1982, the value of one dollar plummeted by 85 percent, from 700 to 100.
- If a saver can earn an interest rate higher than the rate of inflation, they will be protected against inflation. If, for example, inflation is 5% and banks offer a 7% interest rate, those who save in a bank will nevertheless see a real increase in the value of their funds.
If we have both high inflation and low interest rates, savers are far more likely to lose money. In the aftermath of the 2008 credit crisis, for example, inflation soared to 5% (owing to cost-push reasons), while interest rates were slashed to 0.5 percent. As a result, savers lost money at this time.
Workers with fixed-wage contracts are another group that could be harmed by inflation. Assume that workers’ wages are frozen and that inflation is 5%. It means their salaries will buy 5% less at the end of the year than they did at the beginning.
CPI inflation was higher than nominal wage increases from 2008 to 2014, resulting in a real wage drop.
Despite the fact that inflation was modest (by UK historical norms), many workers saw their real pay decline.
- Workers in non-unionized jobs may be particularly harmed by inflation since they have less negotiating leverage to seek higher nominal salaries to keep up with growing inflation.
- Those who are close to poverty will be harmed the most during this era of negative real wages. Higher-income people will be able to absorb a drop in real wages. Even a small increase in pricing might make purchasing products and services more challenging. Food banks were used more frequently in the UK from 2009 to 2017.
- Inflation in the UK was over 20% in the 1970s, yet salaries climbed to keep up with growing inflation, thus workers continued to see real wage increases. In fact, in the 1970s, growing salaries were a source of inflation.
Inflationary pressures may prompt the government or central bank to raise interest rates. A higher borrowing rate will result as a result of this. As a result, homeowners with variable mortgage rates may notice considerable increases in their monthly payments.
The UK underwent an economic boom in the late 1980s, with high growth but close to 10% inflation; as a result of the overheating economy, the government hiked interest rates. This resulted in a sharp increase in mortgage rates, which was generally unanticipated. Many homeowners were unable to afford increasing mortgage payments and hence defaulted on their obligations.
Indirectly, rising inflation in the 1980s increased mortgage payments, causing many people to lose their homes.
- Higher inflation, on the other hand, does not always imply higher interest rates. There was cost-push inflation following the 2008 recession, but the Bank of England did not raise interest rates (they felt inflation would be temporary). As a result, mortgage holders witnessed lower variable rates and lower mortgage payments as a percentage of income.
Inflation that is both high and fluctuating generates anxiety for consumers, banks, and businesses. There is a reluctance to invest, which could result in poorer economic growth and fewer job opportunities. As a result, increased inflation is linked to a decline in economic prospects over time.
If UK inflation is higher than that of our competitors, UK goods would become less competitive, and exporters will see a drop in demand and find it difficult to sell their products.
Winners from inflation
Inflationary pressures might make it easier to repay outstanding debt. Businesses will be able to raise consumer prices and utilize the additional cash to pay off debts.
- However, if a bank borrowed money from a bank at a variable mortgage rate. If inflation rises and the bank raises interest rates, the cost of debt repayments will climb.
Inflation can make it easier for the government to pay off its debt in real terms (public debt as a percent of GDP)
This is especially true if inflation exceeds expectations. Because markets predicted low inflation in the 1960s, the government was able to sell government bonds at cheap interest rates. Inflation was higher than projected in the 1970s and higher than the yield on a government bond. As a result, bondholders experienced a decrease in the real value of their bonds, while the government saw a reduction in the real value of its debt.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
The nominal value of government debt increased between 1945 and 1991, although inflation and economic growth caused the national debt to shrink as a percentage of GDP.
Those with savings may notice a quick drop in the real worth of their savings during a period of hyperinflation. Those who own actual assets, on the other hand, are usually safe. Land, factories, and machines, for example, will keep their value.
During instances of hyperinflation, demand for assets such as gold and silver often increases. Because gold cannot be printed, it cannot be subjected to the same inflationary forces as paper money.
However, it is important to remember that purchasing gold during a period of inflation does not ensure an increase in real value. This is due to the fact that the price of gold is susceptible to speculative pressures. The price of gold, for example, peaked in 1980 and then plummeted.
Holding gold, on the other hand, is a method to secure genuine wealth in a way that money cannot.
Bank profit margins tend to expand during periods of negative real interest rates. Lending rates are greater than saving rates, with base rates near zero and very low savings rates.
Anecdotal evidence
Germany’s inflation rate reached astronomical levels between 1922 and 1924, making it a good illustration of high inflation.
Middle-class workers who had put a lifetime’s earnings into their pension fund discovered that it was useless in 1924. One middle-class clerk cashed his retirement fund and used money to buy a cup of coffee after working for 40 years.
Fear, uncertainty, and bewilderment arose as a result of the hyperinflation. People reacted by attempting to purchase anything physical such as buttons or cloth that might carry more worth than money.
However, not everyone was affected in the same way. Farmers fared handsomely as food prices continued to increase. Due to inflation, which reduced the real worth of debt, businesses that had borrowed huge sums realized that their debts had practically vanished. These companies could take over companies that had gone out of business due to inflationary costs.
Inflation this high can cause enormous resentment since it appears to be an unfair means to allocate wealth from savers to borrowers.