Investment decisions are made after lot of deliberation and considering the micro and macro-economic factors that affect them. Some 50 years ago, with a $10 bill you could buy a lot of things, the value of the $10 bill today and in 1965 is completely different. This phenomenon is known as inflation, and is one of the main factors to be considered when making investments.
What Is Inflation?
Inflation is a sustainable increase in the overall price rise; it is based on the economic concept of the time value of money. That concept states that over time, money loses value. Said another way, over time, prices rise.
Moderate or low level of inflation is associated with economic growth. Every economy has a target rate of inflation that it seeks to achieve; a high rate of inflation above the target rate is a sign of overheated economy. With the growth in economy, consumers and businesses spend more, business hire more, produce more and pay more wages. In the growth stage of an economic cycle, demand exceeds the supply of goods, as a result the rate of inflation increases. However, if this growth accelerates very rapidly the prices of goods and services will continually be raised, this phenomenon is known as hyperinflation.
How is the Inflation measure?
Inflation can be measured by Consumer Price Index (CPI) or Producer Price Index (PPI). The indexes can be thought of as large surveys to gauge the prices of goods and services.
What are the Causes of Inflation?
There is always a debate among economists as to what causes inflation. However, certain forces clearly contribute to inflation.
Inflation can arise from either the demand side or the supply-side of an economy.
Demand pull inflation: Demand pull inflation happens in an expanding economy when the economy is at full employment and the aggregate demand increases leading to price rise. As firms reach their full capacity, they respond by increasing theprices, which leads to inflation. Also, near full employment, workers can get higher wages which increases their spending power. Demand pull inflation can be observed when an economy grows more than the sustainable rate of growth.
Another cause of inflation is Cost Push Inflation mostly observed in a contracting economy, when there is an increase in the costs of firms producing goods and services, the firms then try to pass on those costs to consumers. Cost push inflation can be caused by many factors such as rising wages, import prices, raw material prices, declining profitability, higher taxes etc.
How Does Inflation Affect Investment Returns?
When we talk about inflation, one the question that comes to the mind is: How will it affect Investments, because as inflation rises, every dollar that you own will buy small percentage of goods. Inflation has deep impact on investments and can reduce the value of investment returns. Inflation directly affects all aspects of the economy, spending, investments, employment rates, taxes and interest rates.
However, it affects different assets in different ways and also, whether it is anticipated or unanticipated.Unanticipated inflation comes as a shock to the economy, uncertainty about what will happen next makes companies and consumers less likely to spend. This directly hurts economic output.
The impact of inflation on an investment portfolio depends on the type of securities held; stock prices tend to be less effected in the long run, as over the long run a company’s revenue and earnings are expected to increase at the same pace as inflation. The investors that are hardest hit by inflation are the ones that invest heavily in Fixed Income securities. In the long run People living off a fixed-income, such as retirees; see a decline in their purchasing power and, consequently, their standard of living
We almost always think that inflation is bad, but inflation is not necessarily bad. Inflation is an indication that an economy is growing; the Central bank of a country targets an annual rate of inflation. When the economy is not running at its full capacity, i.e. there is unused labour and resources; inflation usually helps increase the production. Moderate rate of inflation also increases wages for the workers which in turn raise demand for goods and services and increases spending. As a result the economy grows and evils like unemployment and lack of opportunities can be eliminated. In a nut shell inflation is a necessary evil for any economy.