Understanding Inflation and How it Can Affect Your Future

Inflation refers to the general increase in prices as a result of the influence of the money supply or supply of goods. It is essentially a relationship between the quantity of money and productive growth. Inflation is not simply a general increase in prices. Overall price increases could arise as a result of other economic and social factors.

Disinflation and deflation are concepts that arise from the initial concept of inflation. Disinflation refers to a reduction of the inflation rate or a slowing of inflation. Deflation is the polar opposite of inflation. It refers to a contraction in the money supply or a general reduction in prices as a result of the contraction. Inflation is usually seen as necessary for economic growth. However, too much of one thing is good for nothing. Even so, high inflation benefits some investors more than others.

Inflation is important in considering one’s financial future in four main ways:

1) The real return of return of an investment

The real rate of return is the nominal rate of return discounted for inflation. One school of thought is that it is the combined effect of taxes and inflation has a more debilitating effect than inflation risk solely. For example, with deferred annuities, tax is paid at maturity. The returns from an annuity can be discounted for inflation. However, taxation would be levied against the projected nominal return during the payout phase. That would reduce the overall return of taxable investments.

2) Purchasing power risk

This risk arises because of the impact of inflation. Since inflation reduces the nominal returns from investments, the purchasing power of capital may decline with certain investments.

3) Interest rates

In an attempt to control inflation, regulatory bodies may raise or lower lending rates in order to discourage borrowing. However, interest rates in periods of high inflation would increase in order to make investing more attractive than spending.

4) Financial instruments

Some investment-types actually benefit from inflation. These would include higher-order investment instruments like real estate and art for example. With these instruments, higher inflation would increase the absolute returns significantly. The opposite happens to cash and income instruments like fixed deposits and money market funds. Cash and income options are less inimical to your savings and investments in low-inflation periods.

In the same way, inflation does not affect all investments similarly. Investments in items that have intrinsic value, like gold or art would actually thrive in inflationary periods due to their uniqueness. This means that the aggregate demand for these would remain substantial since more money would chase a fixed quantity. Investment classes like cash or bonds and other financial instruments that are indexed to dollar-value perform badly in periods of high inflation. Common stocks thrive in periods of moderate inflation.

Understanding inflation would help us to understand the importance of diversifying our portfolios sufficiently to include growth and income investments. Higher-risk investments limit both purchasing power risk and inflation risk. Investments in annuities must be made after considering the dual combination of inflation risk and taxation that reduce future returns. Knowing the inflation risk with various financial instruments can only benefit the investor.

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