Inflation is the loss of purchasing power of a currency, and poses a significant risk to the ability to keep up with the cost of goods and services over time. The effect it has on investors’ portfolios is also important. The real rate of return represents the return after the impact of inflation. If your salary goes up 2per cent and your portfolio has a 7per cent return, but inflation is 8 per cent, your salary and portfolio will lose 6 per cent and 1per cent of their purchasing power, respectively.
Consumers and investors need to take inflation into consideration, and may want to hedge against inflation. Investors have a number of ways they can hedge the exposure of their investments to inflation, including having a diversified portfolio, choosing different types of assets, and finding higher yielding investments. This article will discuss the types of inflation and strategies for hedging against it.
When people say their dollar does not stretch as far as it used to, they are talking about the effects of inflation on their earnings or wealth. Inflation reduces the purchasing power of their money, so each person prefers their earnings and investments to outpace inflation so they are able to afford more things, even if their prices rise.
Each nation has its own inflation rate, which is a function of its overall economy as well as the impact that its fiscal and monetary policies have on its economy. Inflation can also impact specific areas of an economy, such as the cost of gas or food. There are three types of Inflation that impact an economy: demand-pull inflation, cost-push inflation, and built-in inflation.
The common expression that inflation is too many dollars chasing too many goods is what is referred to as demand-pull inflation. This type of inflation, which results in higher prices for goods and services, is the result of an increase in demand and/or shortages of desired products. Demand-pull inflation impacts consumers through higher prices, and is often associated with easier monetary policy that causes an excess of dollars in the economy, which increases demand for goods.
Cost-push inflation is a rise in the price of products due to producers passing on increased wage and raw materials prices. Also known as wage-push inflation, cost-push inflation results from the general rise in prices due to inflation. Higher prices from wages, which workers demand to keep up with inflation, and materials, which go into the production of goods, often result in a lowering supply of goods. This shifts the supply and demand equation for the product that results in higher prices for products and services.
Built-in inflation is the expected level of inflation in an economy, and is based on past levels of both cost-push and demand-pull inflation, as well as the overall business cycle. Built-in inflation drives economic expectations and planning in an economy.