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.