Investment Basics

Investment Basics: Inflation

Learn about inflation, what causes it and how it can affect a bond portfolio.

  • Understanding inflation is crucial to investing because inflation can reduce the value of investment returns.

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

  • The right fixed-interest investments can help to provide protection against inflation, particularly in the hands of an active manager.

What is Inflation?

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

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. An upward price spiral, sometimes called ‘runaway inflation’ or ‘hyperinflation’, can result.

The inflation syndrome is often described as ‘too many dollars chasing too few goods.’ 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 the purchasing power of a dollar declines.

In general, when economic growth begins to slow, demand eases and the supply of goods increases relative to demand. At this point, the rate of inflation usually drops. Such a period of falling inflation is known as disinflation. Disinflation can also result from a concerted effort by a government and policy makers to control inflation.

When prices actually fall, deflation has taken root. Often the result of prolonged weak demand, deflation can lead to recession and even depression. The longest and most severe period of deflation over the past century occurred in the 1920s and in the 1930s during the Great Depression.

How Is Inflation Measured?

When economists try to measure inflation, they generally focus on ‘core inflation’. Unlike the ‘headline’ or reported inflation, core inflation removes volatile components which can cause unwanted distortion to the headline figure.

There are several regularly reported measures of inflation. The two most widely monitored indicators are:

  • Producer Price Index (PPI): previously called the Wholesale Price Index, the PPI measures prices paid to producers, usually by retailers. Reported monthly, three quarters of the index measures prices of consumer goods, while capital goods prices account for the rest. The PPI picks up price trends relatively early in the inflation cycle.

  • Consumer Price Index (CPI): more widely followed, the CPI reflects retail prices of goods and services, including housing costs, transportation, and healthcare.

Causes of Inflation

Rising commodity prices often cause inflation. When commodities rise in price, the cost of basic goods and services generally increase. Higher oil prices especially can have an inflationary impact. Higher oil prices mean that petrol prices will rise, which pushes up the prices of all goods and services that are transported by truck or ship. Jet fuel prices go up, raising the prices of airline tickets and air transport. Heating oil prices also rise, hurting consumers and businesses.

By causing price increases throughout an economy, rising oil prices take money out of the pockets of consumers and businesses. Economists therefore view oil price hikes as a ‘tax’ that can depress an already weak economy. Surges in oil prices were followed by recessions or stagflation—a period of inflation combined with low growth and high unemployment--in the 1970s, 1980s and early 1990s.

In addition to oil price hikes, exchange rate movements can cause inflation. As a country’s currency depreciates, it becomes more expensive to buy imports, which puts upward pressure on prices overall.

Over the long term, currencies of countries with higher inflation rates tend to depreciate relative to those with lower inflation. Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation.

Investment Returns and Inflation

Inflation poses a 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 per cent before inflation in an environment of 3 per cent inflation will produce a negative return (-1 per cent) when adjusted for inflation.

Inflation can be harmful particularly to fixed-income returns. Many investors buy fixed-income securities because they want a stable income stream, which comes in the form of interest payments. However, because the rate of interest, or coupon, on most fixed-income securities remains the same until maturity, the purchasing power of the interest payments declines as inflation rises.

Suppose, for example, an investor buys a five-year bond with a principal value of $100. If the rate of inflation is 3 per cent annually, the value of the principal adjusted for inflation will sink to about $84 over the five-year term of the bond. Because of inflation’s impact, the interest rate on a fixed-income security can be expressed in two ways:

  • Nominal rate: the rate of interest on a bond without any adjustment for inflation (also called the ‘stated rate’). The nominal interest rate reflects two factors: the rate of interest that would prevail if inflation were zero (the real rate of interest) and the expected rate of inflation, which shows that investors demand to be compensated for the loss of return due to inflation. Most economists believe that nominal interest rates reflect the market’s expectations for inflation: rising nominal interest rates indicate that inflation is expected to climb, while falling rates indicate that inflation is expected to drop.

  • Reall interest rate: the nominal rate minus the rate of inflation. Because it takes inflation into account, the real interest rate is more indicative of the growth in the investor’s purchasing power. If a bond has a nominal interest rate of 5 per cent and inflation is 2 per cent, the real interest rate is 3 per cent.

Inflation can adversely affect fixed-income investments in another way. When inflation rises, interest rates also tend to rise. When interest rates rise, bond prices fall. Thus, inflation may lead to a fall in bond prices, potentially reducing total returns on bonds.

Unlike bonds, some assets rise in price as inflation rises:

  • Shares have often been a good investment relative to inflation over the long term because companies can raise prices for their products when their costs increase. Higher prices may translate into higher earnings. However, over shorter time periods, stocks have often shown a negative correlation to inflation and can be especially hurt by unexpected inflation and the economic uncertainty it creates. This can lead to lower earnings forecasts for companies and lower equity prices.
  • Commodity prices generally rise with inflation. Commodity futures, which reflect expected prices in the future, might therefore react positively to higher inflationary expectations.

Protecting Against Inflation

To combat the negative impact of inflation, the returns on some types of fixed-income securities are linked to changes in inflation:

  • Floating-rate notes offer coupons that rise and fall with key interest rates. The interest rate on a floating-rate security is reset periodically to reflect changes in a base interest rate index, such as the Bank Bill Swap Rate (BBSW) or the London Interbank Offered Rate (LIBOR). Floating-rate notes have therefore been positively, though imperfectly, correlated with inflation.

  • Inflation-linked bonds (ILBs) issued by many governments are explicitly tied to changes in inflation. ILBs protect investors from inflation because both their principal and their interest payments are linked to CPI changes.

Many commodity-based assets, such as commodity Indexes, can help cushion a portfolio against inflation because their total returns usually rise in an inflationary environment.

Controlling Inflation

Central banks, including the Reserve Bank of Australia (RBA), attempt to control inflation by regulating interest rates. The RBA can lower short-term rates, which encourages banks to borrow from the RBA and each other, effectively increasing the money supply. Banks make more loans to businesses and consumers, which stimulates spending, which pressures inflation higher.

Raising short-term rates has the opposite effect: it discourages borrowing, decreases the money supply, dampens economic activity and subdues inflation.

Management of the money supply by central banks is known as monetary policy. Raising and lowering interest rates is the most common way of implementing monetary policy. However, the RBA can also tighten or relax banks’ reserve cash requirements. Banks must hold a percentage of their deposits with the RBA or as cash on hand. Raising the reserve requirements restricts banks’ lending capacity, thus slowing economic activity. Easing reserve requirements generally stimulates economic activity. Inflation in Australia has fallen significantly since the 1970s and 1980s as can be seen in the graph below.

Governments at times attempt to fight inflation through fiscal policy, dampening economic activity by raising taxes or reducing spending. Conversely, they can try to combat deflation with tax cuts and increased spending which is designed to stimulate economic activity.

Your Investment

In an environment of rising inflation, active fixed income managers generally do better than passive, or index, managers as they can re-allocate client assets to sectors of the fixed-income market which offer the most protection from inflation.


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