Inflation has thrown countries into long periods of insecurity. Politicians have won elections by promising to combat inflation, only to lose power after failing to do so. Central bankers frequently aspire to be known as “inflation hawks.” This begs the question, what causes inflation, and why is it so important?
The early 2020 COVID-19 pandemic resulted in lockdowns and other restrictive measures severely disrupting global supply chains. Russia’s unprovoked invasion of Ukraine in early 2022 resulted in a slew of economic sanctions and trade restrictions against the country, limiting the world’s oil and gas supply because Russia is a major producer of these commodities. At the same time, food prices rose due to the inability of Ukraine’s large grain harvest to be exported. As fuel and food prices rose, so did prices further down the value chain.
Inflation and its causes
Inflation is defined as an increase in prices over a specific period, resulting in a decline in purchasing power over time.
Inflation is caused by an increase in money supply, which can manifest itself through various economic mechanisms. A nation’s monetary authority has the power to raise the amount of money in the country by either decreasing the value of the legal tender money in a legal manner, printing more cash and distributing them accordingly to citizens or by using the most common method of lending new money into existence.
The value of the money decreases in each of these scenarios. The mechanisms that drive inflation can be divided into three types, usually demand-pull inflation which happens when there is not enough supply of goods or services to satisfy demand, which then drives up prices. Cost-push inflation occurs when the cost of producing goods and services rises, forcing businesses to raise their prices while built-in inflation happens when employees demand higher wages to keep up with rising living costs. This, in turn, causes businesses to raise their prices to offset rising wage costs, creating a self-perpetuating cycle of wage and price increases.
How do you hedge against inflation?
There are numerous ways for investors to hedge, or protect against, inflation, including some investments designed specifically for this purpose. Hedging against inflation entails taking steps to protect an investment’s value from the effects of inflation.
For example, if an asset increases in value by 5% per year but inflation is 6%, the real return on that asset is -1%. The Federal Reserve typically targets a long-term average inflation rate of 2%, but there have been times when inflation has exceeded 17% per year.
There are a few options for hedging against inflation. One option is to invest in assets whose value is linked to inflation. When inflation rises, so will their values. Another option is to invest in securities designed specifically to hedge against inflation. Some bonds, for example, will pay an interest rate that is partially determined by the inflation rate.
Certain asset classes perform better than others at hedging against inflation. Gold and other precious metals, Treasury inflation-protected securities (TIPS), floating-rate bonds, certain stocks, real estate, and certain commodities are examples. Incorporating some of these items into your portfolio can assist you in keeping up with inflation over time.
Everyone is affected by inflation. Inflation gradually reduces the purchasing power of your money, whether you have $1 or $1 billion.
Individual investors, particularly those with long-term investment plans, should consider how inflation will impact their investments. This could imply allocating a portion of your portfolio to inflation hedges or opting for a more aggressive asset allocation to help boost returns.