Definition and Example of Inflation
Inflation is an economic term that refers to a general increase in the prices of goods and services within a particular economy. As general prices rise, the purchasing power of consumers decreases. The measurement of inflation over time is referred to as the inflation rate. People often refer to inflation as “the rising cost of living.”
Investing to Stay Ahead of Inflation
Most people invest their savings in investment vehicles like mutual funds because they want to use their money to make money. What they may not realize is that by investing, they are also trying to outpace inflation. If you keep your money by burying it in jars in the backyard or hiding it under your mattress, you are losing money due to inflation because the cost of living is rising while the value of your money remains unchanged.
In fact, if your bank account or certificate of deposit does not yield more than the average increase in inflation for that year, you may be losing value.
For example, the average inflation rate for 2019 was 2.2%. Suppose you placed $100 in a certificate of deposit in January 2019, earning 2.5% annually at your local bank. If you left this amount in the certificate for a full year, it would earn $2.50 in interest, raising the value of the certificate to $102.50.
The purchasing power of the $102.50 increased by 0.30% (2.5% – 2.2% = 0.30%). Therefore, the purchasing power of the certificate becomes $102.81 (using the average inflation rate for one year). You have “beaten” inflation with this investment, increasing its value by $0.31.
However, if the certificate of deposit earned an annual rate of 1.5%, you would earn $1.50 (totaling $101.50), and the value would decline by 0.7% (1.5% – 2.2% = -0.7%). The purchasing power of the certificate would be $100.78. You would lose 72 cents due to inflation (at the average inflation rate for one year).
Therefore, in a low-interest environment, you can earn money in a certificate of deposit while still losing purchasing power due to inflation and taxes – you are doing what can be called “safely losing money.”
The best way for most people to beat inflation – to achieve returns that exceed the average inflation rate – is to invest in a mix of stocks and mutual bond funds that can yield more than the average inflation rate.
Investment Strategies and Inflation Hedging
What most people think of when considering inflation (gradual rising cost of living) isn’t entirely bad from an investor’s perspective. Inflation can actually be beneficial. Economists have pointed out that a healthy balance between inflation and economic growth is considered the “Goldilocks economy,” as it is a “just right” balance for investment, business growth, employment, and consumer activity.
This ideal balance occurs when the inflation rate is at or below average, and economic growth is slightly above the average inflation rate. This is the environment where stock prices can rise and bond prices remain stable because there is no need for external economic stimulus (monetary or fiscal policy).
When inflation exceeds the Goldilocks level (more than 2%), the value of the dollar may start to decline. Therefore, foreign stock funds can be a natural hedge as invested money in foreign currencies converts into more dollars at home (as long as the exchange rates in the invested countries do not decline as well).
Categories of mutual funds that may perform well in inflationary environments include inflation-protected bonds (TIPS) and bond funds best for rising interest rates – such as short-term bond funds. (Long-term bond funds carry more risk than short-term funds.)
Warning
Investing in Inflation
Navigating the market and economic conditions with investment strategies is a form of market timing that carries significant risks of losing investment value. For most investors, building a diversified portfolio of mutual funds is the strategy recommended by professional investors and financial planners to cope with most economic and market conditions.
Frequently Asked Questions (FAQ)
What causes inflation?
In the simplest terms, inflation is just a reflection of the ever-fluctuating relationship between supply and demand. When demand factors outpace supply’s ability to adjust, prices rise. Similarly, when there is negative pressure on supply, such as rising production costs, prices will increase. These shifts occur for many reasons, including changes in consumer confidence, rising wages, government policies, global disasters, and more.
How can I know the inflation rate?
Inflation can be measured against two main price indicators: the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) index. To calculate the inflation rate for a given period, subtract the index price at the beginning of the period from the price at the end, then divide that number by the price at the beginning. Although the Consumer Price Index is more widely used to measure inflation, the Federal Reserve relies on the PCE index to gauge inflation and employs several variations to assess different types of inflation.
Why is inflation important?
Inflation affects the economy in many important ways. Rising prices mean that the value of the dollar declines for both consumers and businesses. Tax rates and brackets at the Internal Revenue Service are based on the inflation rate. On the other hand, a low inflation rate may indicate that the economy is experiencing a recession. Although some sectors and individuals are more insulated from the effects of inflation, it impacts everyone in some way. For this reason, many Federal Reserve policies aim to control the inflation rate.
Was this page helpful?
Thank you for your feedback! Let us know why! Other
Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts contained in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.
U.S. Bureau of Labor Statistics. “Databases, Tables, and Calculators by Subject. Check ‘Include Annual Averages’, select ‘From: 2019’ and ‘To: 2019’, then click ‘Go’.”
Board of Governors of the Federal Reserve System. “Why does the Federal Reserve aim for 2 percent inflation over time?”
Federal Reserve Bank of San Francisco. “What are some factors that contribute to rising inflation?”
The Brookings Institution. “How does the government measure inflation?”
Source: https://www.thebalancemoney.com/inflation-definition-examples-and-investing-strategies-2466838
Leave a Reply