What is inflation? Should investors worry about it?

Summary

• Inflation can be described as a fall in purchasing power of a given currency over time.
• The prices rise as more dollars chase relatively fewer goods.
• Inflation directly impacts the return on investments. 

Inflation is one thing that investors globally are the most concerned about because it directly impacts the rate of return on investments. Based on the inflation numbers, the investors calculate the level of returns their investments must make to maintain their living standards.

What is inflation?

Inflation can be described as a fall in purchasing power of a given currency over time. It refers to the rise of prices of services and goods of everyday use such as clothing, housing, and consumers items. The prices rise as more dollars chase relatively fewer goods. Inflation is the measure of average price change in a basket of commodities and services over a period.

READ MORE: How Inflation Affects Your Investments And Finances

We can understand the concept easily through an example. A person can purchase a burger for $3 this year at an annual inflation rate of 10%.

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If the inflation increases by the same rate next year, the same burger will cost the person 10% more or $3.30. So, the person would have to increase his income by at least same inflation rate to buy the burger.

Key reasons for inflation

Inflation can be triggered by several factors. However, there are five common reasons for the rise in prices.

• A demand-supply mismatch created due to high demand and low production or supply of commodities.
• Excess circulation of money in the system can lead to money losing its purchasing power.
• Increased spending by the people.
• Cost-push inflation or a rise in production prices of commodities can increase costs of final products.
• A rise in prices of goods and services.

READ MORE: How is inflation calculated?

Should investors be worried about inflation?

The rise in prices or inflation can impact the cost of living and borrowing and bond yields. Thus, inflation can be both beneficial and detrimental for an economy. At reasonable and controlled levels, inflation can help the economy to grow. However, the inflation can impact the economy if it becomes too high and gets out of control.

The cost of borrowing comes down when both inflation and interest rates are low, encouraging consumption. However, it has also been seen that banks and other lending institutions are reluctant to lend at low rates as this decreases their profit margins.

Different people perceive inflation differently. For instance inflation can benefit an investor invested in real estate or stocked commodity since the prices of these assets rise as a result. However, the ones with cash can be adversely impacted as inflation reduces the purchasing power of the money.

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Impact on bonds

The bond prices have an inverse relationship with interest rates and yields. The rates generally rise, pushing down bond prices due to inflation. A rise in both interest rate and yields means a falling price and a lower principal value for your fixed-income investment.

What should investors do when inflation takes off?

Investors should ensure that they always have an alternative investment plan. Investors can save their investments using several plans:

• The first and foremost is to increase allocation in equities when inflation rises. The reason is that companies generally pass their costs to customers when prices of commodities and services rise. Value investors may benefit most in such a scenario.
• Investors can buy inflation-linked bonds to protect their savings from inflation.
• Gold is generally considered an inflation-hedge, and investors increase their allocation in the yellow metal in such a scenario.

So, investors should always purchase investment products that give returns equal to or greater than the inflation rate. For instance, if X stock gave a return of 5% while inflation was 8%, the real rate of return stood at -3%. Generally, investors ignore this detail and lose in future as inflation increases. Therefore, investors should adequately do their homework or consult their financial planners before going ahead with an investment so that they buy a good product.

You can invest in several inflation-protected securities such as inflation-indexed bonds or Treasury inflation-protected securities (TIPS) to protect your investment returns over a long period.

How is inflation measured?

Inflation is measured through the consumer price index (CPI). The index includes ‘basket’ of essential goods and services, such as food, energy, clothing, and housing. Inflation is measured by a central government authority, which adopts measures to ensure the smooth running of the economy.

A few other indices used to calculate inflation are the Wholesale Price Index (WPI) and Producer Price Index (PPI). The wholesale price index works almost in the same way as CPI. However, the price level taken in the basket of goods is the wholesale price level, not the retail price level.

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