Inflation — the stealth threat to investments

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.

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.

In the U.S., the inflation syndrome is often described as “too many dollars chasing too few goods”. In other words, as spending outpaces the production of goods and services, the supply of dollars in an economy exceeds the amount needed for financial transactions. The result is that the purchasing power of a dollar declines.

How is inflation measured

When economists and central banks try to discern the rate of inflation, they generally focus on “core inflation,” such as “core CPI” or “core PCE”. Unlike the “headline,” or reported 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. In the US, 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. The Federal Reserve prefers to emphasise the Personal Consumption 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), or the Harmonized Index of Consumer Prices (HICP). In the Eurozone, the main measure used is also called the HICP.

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 central 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.

How can inflation be controlled?

Central banks, such as the US Federal Reserve, European Central Bank, the Bank of Japan and the Bank of England attempt to control inflation by regulating the pace of economic activity. They usually try to affect economic activity by raising and lowering short-term interest rates.

Management of the money supply by central banks in their home regions is known as monetary policy. Raising and lowering interest rates is the most common way of implementing monetary policy.

However, a central bank can also tighten or relax banks’ reserve requirements. Banks must hold a percentage of their deposits with the central bank or as cash on hand. Raising the reserve requirements restricts banks’ lending capacity, thus slowing economic activity, while easing reserve requirements generally stimulates economic activity.

A government at times will attempt to fight inflation through fiscal policy. Although not all economists agree on the efficacy of fiscal policy, the government can attempt to fight inflation by raising taxes or reducing spending, thereby putting a dampener on economic activity; conversely, it can combat deflation with tax cuts and increased spending designed to stimulate economic activity.

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 impacts on portfolios?

Amid a rising inflation environment and constantly changing investment conditions, investors may want to 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.

This article was originally published by PIMCO.

PIMCO is one of the world's premier fixed income investment managers managing $2 trillion in assets for central banks, sovereign wealth funds, public and private pension funds, corporations, foundations and endowments, and individual investors. Founded in 1971, PIMCO introduced investors to a total return approach to fixed income investing. In the 50 years since, PIMCO has continued to bring innovation and expertise to its partnership with clients seeking the best investment solutions. Today the firm has offices across the globe and professionals united by a single purpose: creating opportunities for investors in every environment. PIMCO is owned by Allianz S.E., a leading global diversified financial services provider.

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PIMCO disclaimer

Please note that the following contains the opinions of the manager as of the date noted and may not have been updated to reflect real time market developments. All opinions are subject to change without notice.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

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The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. The Personal Consumption Expenditures (PCE) deflator is published by the Bureau of Economic Analysis as part of the GDP report. It measures inflation across the basket of goods purchased by households, and is computed by taking the difference between current dollar PCE and chained dollar PCE. The Harmonised Indices of Consumer Prices (HICP) is an economic indicator that measures the changes over time in the prices of consumer goods and services acquired by households. The HICP gives a comparable measure of inflation in the euro-zone, the EU, the European Economic Area and for other countries including accession and candidate countries. It is calculated according to a harmonised approach and a single set of definitions. It also provides the official measure of consumer price inflation in the euro-zone for the purposes of monetary policy in the euro area and assessing inflation convergence as required under the Maastricht criteria. It is not possible to invest directly in an unmanaged index.

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