Rising prices of goods and services reduce the purchasing power of one’s currency. This reduction in the purchasing capacity of the currency is known as inflation. Kavan Choksi / カヴァン・ チョクシ points out that inflation is an economy-wide, sustained trend of increasing prices from one year to the next. The rate of inflation represents how fast investments lose their real value, as well as how quickly prices increase over time. Investors must keep an eye on the inflation rates to identify how much ROI they need to maintain their standard of living.
Kavan Choksi / カヴァン・ チョクシ sheds light on how inflation impacts investments
There are a number of factors that can influence inflation, like increased demand and production costs. Monetary policy, like tax cuts or lower interest rates, also has a significant impact on inflation rates. Consumer expectation is also a less-tangible, psychological factor that impacts inflation. It applies to a situation where a period of inflation lasts for a long time, and hence people might expect it to continue indefinitely. They may ask employers for salary hikes to help them keep up with the higher cost of living. Companies may subsequently increase the prices they charge consumers, which would further fuel inflation.
To understand how inflation impacts one’s investment returns, it firstly is crucial to differentiate between nominal and real interest rates.
- The nominal rate of interest basically is the rate of interest without any adjustment for inflation. This tends to be the stated interest rate on most securities, the exception being inflation-protected securities, like TIPS bonds.
- The real interest rate is the nominal interest rate minus the rate of inflation. This interest rate accounts for inflation, and shows one’s actual gain or loss in purchasing power.
To achieve a real return, an investor’s nominal interest earnings need to match or exceed the rate of inflation. When inflation rises and interest rates remain low, the purchasing power of investment returns goes down. As a result, investments that offer lower interest rates are more vulnerable to being eroded by inflation, diminishing their overall value over time. Inflation may considerably reduce real returns on fixed-income investments like corporate or municipal bonds and CDs.
As per Kavan Choksi / カヴァン・ チョクシ, investors generally purchase fixed income securities as they desire a stable income stream in the form of interest payments. But as the income stream stays the same on the majority of the fixed-income securities until maturity, the purchasing power of the interest payments goes down as inflation rates climb up. Therefore, bond prices tend to fall when inflation is increasing.
Real assets like real estate and commodities generally have a positive relationship with inflation. Historically, commodities have been considered to be a dependable way to position for rising inflation. Inflation tends to be measured by tracking the price of goods and services that often contain commodities, as well as products closely related to commodities. Commodities associated with energy, such as oil, especially have a strong relationship with inflation. The price of precious metals also generally rises when inflation is accelerating. In the case of real estate, property owners typically increase rent payments in line with the CPI.
