Inflation is an important determinant of any country’s economic health. In this article, we consider inflation in more detail and ask how it impacts investments. We also explore some strategic approaches to minimising the risks presented by inflation.
What is inflation?
Inflation is typically understood as the rate at which prices increase over time. This is known as the inflation rate. The effect of inflation is that the same amount of currency is able to buy fewer goods or services. It is traditionally understood to mean too much money chasing too few goods or services. This happens when the money supply in the economy exceeds the level of productive output. The rate of inflation is an indicator of investments losing real value. It is a useful gauge of what percentage return you need to make on a worthwhile investment.
How inflation works
Inflation is calculated in different ways. In the UK, it is estimated by the Office of National Statistics (ONS), when it assesses a range of popular consumer foods, goods, or services. Their prices are compared with the same period the year before. The rise in prices is used to determine the rate of inflation. The result is the Consumer Price Index (CPI). This common tool is used to track fluctuations in the prices of your typical household ‘basket’ of everyday goods and services.
The causes of inflation
Inflation can be attributed to different causes. Demand-pull inflation happens when supply cannot keep up with demand. This might be attributed to government spending, economic growth, greater export demand or an increased money supply. Then, there is cost-push inflation. This refers to the impact of increases in the cost of production. It could be caused by rising wages, supply chain disruption, or increased material or energy costs.
Built-in inflation is a variant of inflation that is also known as wage-price inflation. This occurs when wages and prices influence one another in a cyclical, sometimes symbiotic pattern. Central banks too, sometimes at the behest of national governments, can drive inflation. By adjusting interest rates and the money supply, banks are able to drive up prices by increasing the number of banknotes in circulation.
How inflation affects investments
Several investments will be impacted by inflation. With a reduction in spending capability, purchasing power is diminished. If an investment grows at 5% but against a backdrop of 1% inflation, the real return is only 4%. This is why it is extremely important for people to fully understand their investment strategies. You should be looking at purchasing investment products which match or beat inflation. For prudent investors, it is crucial that investment returns are at least as high as inflation. Otherwise, your investments will lose value. To ensure you retain purchasing power, your salary should keep up with inflation.
The impact inflation has on different investment types
The impact of inflation will invariably depend on the type of asset you hold. With stocks, inflation affects the degree of purchasing power. It is something to bear in mind if opting for individual stocks or a stocks and shares IPA. Bonds too can be impacted by reduced purchasing power, especially when pegged to fixed interest rates. Inflation can influence house prices in the property market, because mortgage rates might follow inflation rises.
Liquid assets, such as cash, short-term bonds, or marketable securities, offer stability and ease of conversion, without losing noticeable value. Higher inflation rates, however, mean liquid assets are more vulnerable to inflation. Many investors will opt for illiquid assets such as stocks, bonds and mutual funds, precisely to protect savings from inflationary pressures. Some people will protect longer-term investment returns and purchasing power by investing in Treasury inflation-protected securities or inflation-indexed bonds.
The effect of inflation on your savings
Savings can also be hit by inflation. It is important you check that interest rates on a savings account are set to beat inflation. To calculate this, you should deduct the inflation rate from the ‘nominal’ interest rate in order to work out the ‘real’ rate of interest being earned.
To find out more about inflation and how it could affect your savings and investments, call us today to set up a consultation. Our specialist team of financial advisers at Hartey Wealth Management are leading providers of savings advice in Cheshire.
