Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programs, tax policies, and interest rates.

Understanding inflation is crucial to investing because it can reduce the value of investment returns. With inflation rising recently after several years of relative calm to its highest level in four decades, investors may benefit from knowing the factors driving inflation, the impact on their portfolios, and steps to consider as the investment landscape shifts.

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What is Inflation?

As an economy grows, businesses and consumers spend more money on goods and services. In the growth stage of an economic cycle, demand typically outstrips the supply of goods, and producers can raise their prices. As a result, the rate of inflation increases.

Inflation is a sustained rise in overall price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy.

If economic growth accelerates very rapidly, demand grows even faster and producers raise prices continually. An upward price spiral, sometimes called “runaway inflation” or “hyperinflation,” can result.

How Is Inflation Measured?

When economists and banks try to discern the rate of inflation, they generally focus on “core inflation,” such as “core CPI”. Unlike the inflation, core inflation excludes food and energy prices, which are subject to sharp, short-term price swings, and could give a misleading picture of long-term inflation trends.

There are several regularly reported measures of inflation that investors can use to track inflation. The Consumer Price Index (CPI), which reflects retail prices of goods and services including housing costs, transportation, and healthcare, is the most widely followed indicator.

What Causes Inflation?

Economists do not always agree on what spurs inflation at any given time, but in general they bucket the factors into two different types: cost-push inflation and demand-pull inflation.

Rising commodity prices are an example of cost-push inflation because when commodities rise in price, the costs of basic goods and services generally increase.

Demand-pull inflation occurs when aggregate demand in an economy rises too quickly. This can occur if a bank rapidly increases the money supply without a corresponding increase in the production of goods and service. Demand outstrips supply, leading to an increase in prices.

Expenditures Price Index (PCE). This is because the PCE covers a wider range of expenditures than the CPI. The official measure of inflation of consumer prices in the UK is the Consumer Price Index (CPI).

How Does Inflation Affect Investment Returns?

Inflation poses a “stealth” threat to investors because it chips away at real savings and investment returns. Most investors aim to increase their long-term purchasing power. Inflation puts this goal at risk because investment returns must first keep up with the rate of inflation in order to increase real purchasing power.

For example, an investment that returns 2% before inflation in an environment of 3% inflation will actually produce a negative return (−1%) when adjusted for inflation.

What May Inflation Mean For Investors?

Very high inflation tends to have a negative impact on assets such as stocks and bonds. Maintaining a constant allocation to inflation-hedging assets can help investors cushion their portfolios against unexpected spikes.

What Steps Can Investors Take To Mitigate Inflation’s Impact On Portfolios?

Amid a rising inflation environment and constantly changing investment conditions, investors may want to consider inflation-mitigating assets, as well as to keep in mind the core tenets of investing—maintaining a well-diversified portfolio, regular rebalancing, and ensuring investments remain aligned with long-term goals.

PLEASE NOTE: The value of investments, and any income from them, can fall and you may get back less than you invested.  Neither simulated nor actual past performance are reliable indicators of future performance. Information is provided only as an example and is not a recommendation to pursue a particular strategy.