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- Five facts investors should know about inflation
- Central banks have flooded the financial system with liquidity in response to the corona crisis, fueling a debate about the potential risks of rising inflation.
- Rising inflation reduces the purchasing power of money and leads to diminishing wealth.
- Investors should invest in a way that keeps their returns above inflation over the long term.
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The average inflation during the period of hyperinflation in Germany in 1923 was 322 %
Source: Phillip D. Cagan, The Monetary Dynamics of Hyperinflation, Chicago 1956
Around the globe governments launched fiscal rescue packages over unprecedented amounts in the wake of the corona pandemic, causing a dramatic increase in public debt. This has raised the question of how the high volumes of debt can ever be repaid in the future. Through economic growth? Budget surpluses? Or will the debt be inflated away? For Martin Moryson, Chief Economist Europe at DWS, it is by no means certain whether the corona crisis will lead to higher inflation in the long term (see the article: "Corona crisis: Who will pay for it?").[1] Nevertheless, it may be worthwhile for investors to take a detailed look at the potential implications of rising inflation. Here is an overview of the most important questions and answers on the subject of inflation.
1. What is inflation?
Inflation is defined as the increase in prices of goods and services, usually occurring over the course of a year. Statisticians measure inflation using a basket of various goods. In Germany the Federal Statistical Office (Destatis) publishes the inflation rate every month (Destatis).[2]
Inflation is generally associated with a loss of the purchasing power of money: After a year, people can buy fewer goods for the same amount of money in visual terms.
A poor harvest increases food prices – as there are fewer goods available for money to chase. However, in addition to supply and demand changes, other factors may be responsible for rising inflation, such as government borrowing and a subsequent money supply expansion facilitated by the central bank, which then devalues the money held in physical cash or bank deposits.
The opposite of inflation is deflation – in other words, a sustained decline in the level of prices for goods and services. Here the main risk is that both consumers and companies would have an incentive to put aside their increasingly valuable money and postpone purchases and investments over and over again. This would trigger an economic downward spiral.
2. Why do central banks like the ECB have an inflation target of two per cent per year?
The primary objective of the European Central Bank (ECB) is to maintain monetary stability in the euro area.[3] As such, the central bank has committed itself to an inflation target of “below but close to two percent” – and not zero percent, as might seem logical at first glance.
Explanation: The ECB wants to eliminate the risk of deflation - i.e. the opposite of inflation – and establish a “sufficient safety margin”[4] to this end. For at roughly the same cost, combating deflation by monetary policy means would be subject to limits at an interest rate of zero – which the central bank itself, however, has been undercutting since 2014 with a negative deposit rate for commercial bank deposits at the ECB. This has contributed to the fact that even government bonds from the euro area, including Germany, pay a current yield of less than zero percent.
3. What are the risks associated with inflation?
Inflation reduces the purchasing power of money: For example, if an employee always receives the same nominal wage, he or she can afford less and less because of rising prices. Savers should also keep an eye on inflation trends: If inflation rises, savings and assets shrink in real terms. Capital invested at a lower rate of return than the inflation rate steadily loses purchasing power. For this reason, investors need to make sure that the interest rate or yield on their investments is above the inflation rate.
4. How to protect against inflation?
Real assets can usually provide protection against inflation. These include gold, which has been considered a store of value by mankind for thousands of years, which is one of the reasons why it was minted into coins in earlier times. Real estate is also regarded as a real asset: Owning your home is perceived as a value, which means that residential real estate prices tend to move in the same direction as inflation – especially since landlords can usually also adjust rent payments from their tenants in line with inflation over a long period of time.
Equities are real assets as well: They represent ownership interests in a company, which in turn owns other real assets – and shareholders therefore own a small part of these assets. These could be administrative buildings or machinery, for instance. Thus it is quite common to see share prices rise on the equity markets when inflation rates pick up.
In addition, investors could take advantage of inflation-indexed bonds, in which the nominal value and/or the coupon are linked to consumer price trends. If inflation rises, for example, the coupon payment due on these securities increases accordingly.
5. What is not suitable to protect against inflation?
Cash, for example. The purchasing power of cash is directly impacted by inflation. With the small change in the piggy bank you might be able to buy one ice cream less after one year. The same is true for current account balances with banks. The money that savers have parked in overnight money market accounts, for example, also loses real value. This is because the interest rate paid on them is currently below the inflation rate, resulting in a gradual loss of real capital. Such a loss can be significant: After ten years and adjusting the amount for inflation of two per cent annually, as the ECB is targeting, an amount of EUR 8,000 will have a remaining purchasing power of only EUR 6,536.58. Even if the nominal value has not changed, in real terms this is almost EUR 1,500 less.
