Inflation Risk: Causes and Effects

Investors and traders alike are well aware of the term “inflation.” They know it isn’t a buzzword but a real-life phenomenon that can potentially send their hard-earned net worth up in smoke.

Over the past century, the U.S. has experienced both high and low inflation. For example, during the 1970s, the country faced stagflation, a period of high inflation with high unemployment and slow economic growth. In more recent decades, inflation has generally been relatively low and stable.

But fast forward to the 2020s, and a great deal of public attention (and anxiety) is concentrated on the rising costs of groceries, housing, and consumer goods. 

In this guide, we’ll discuss inflation risk, including the causes of inflation, how it affects various investment avenues, and how to protect yourself from it.

Definition of inflation risk

Think of inflation risk as the slow but persistent thief that erodes the purchasing power of your capital, i.e., your cash.

Imagine you've diligently saved and invested your money, aiming to grow and secure your wealth over the long term. However, if the rate of return on your investments (ROI) fails to outpace the inflation rate, your nest egg may not grow as much as you expect. In fact, it could lose value in real terms. 

This is where the crux of inflation risk lies—when the prices of everyday items increase faster than your investment returns, your wealth diminishes, and your financial goals become more burdensome to reach.

Economists often use both “headline inflation” and “core inflation” figures to get a comprehensive view of price trends. 

Headline inflation

This refers to the overall rate of inflation that’s typically reported in economic data and news headlines. It includes the price changes of all goods and services in a basket of consumer goods, including essential items like food and energy. 

Core inflation

Conversely, core inflation excludes volatile food and energy prices to focus on items such as medical care, education, and even the cost of movie tickets. It measures underlying inflationary pressures.

What causes inflation?

Inflation is not a one-size-fits-all phenomenon. It has several underlying causes, each with its own unique impact. Here are a few:

Monetary factors

One of the primary (and best-known) culprits behind inflation is monetary policy. Central banks, such as the Federal Reserve in the U.S., can influence inflation through their money supply control. When central banks increase the money supply by printing more currency or lowering interest rates, they flood the financial system with excess cash. This abundance of money can increase demand for goods and services, which, in turn, can drive prices. 

This is a classic case of too much money chasing too few goods. Banks, at this time, tend to look for inflation-easing measures.

Demand-pull inflation

Demand-pull inflation occurs when the overall demand for goods and services in an economy outpaces the ability to supply them. This can happen for many reasons, such as increased consumer spending, business investments, or government expenditure. When demand exceeds supply, sellers can raise prices to capitalize on the higher demand. This type of inflation is often seen during economic expansion when consumer and business confidence is high.

Cost-push inflation

Cost-push inflation, on the other hand, arises from the economy’s supply side. It occurs when the cost of producing goods and services rises, forcing businesses to pass those increased costs onto consumers in the form of higher prices. 

Factors contributing to cost-push inflation typically include rising wages, increased raw material prices, or supply chain disruptions. For example, a sudden spike in oil and gas prices can lead to higher transportation costs, affecting an incredibly wide range of products and services, from eggs to autos.

Built-in inflation

Sometimes, inflation can be a self-fulfilling prophecy. When workers and businesses expect prices to rise, they may demand higher wages and/or charge higher prices for their products and services. This built-in inflation (or wage-price inflation) can create a feedback loop where rising prices lead to higher wages, which, in turn, fuel price increases. 

Exchange rate movements

Exchange rates play a tremendous role in determining the prices of imported goods. When a national currency (like the U.S. dollar) depreciates against foreign currencies, purchasing goods and services from overseas becomes more expensive. These increased costs can then be passed on to consumers in the form of higher prices.

How does inflation affect investments?

It’s smarter to develop a plan to deal with inflation rather than helplessly asking yourself unanswerable questions like “When will inflation go down?” So let’s look at how inflation affects investments and explore strategies to hedge against inflation risk. 

Impact on stocks

Decreased purchasing power

Inflation compromises consumers’ purchasing power, reducing their ability to buy goods and services. This can reduce consumer spending, potentially affecting companies' revenue and profit margins.

Rising costs

Companies may face rising production and operating costs due to inflation. For example, higher raw material and labor costs can squeeze profit margins, affecting a company's profitability.

Volatile stock prices

Inflation can lead to greater uncertainty in many financial markets, and the stock market is no exception. Here, inflation tends to contribute to increased volatility in share prices. Understandably, investors often demand higher returns to compensate for the increased risk associated with inflation, leading to further fluctuations in stock prices.

Effect on bonds

Reduced principal

Fixed-rate bonds––like traditional government, corporate, or municipal bonds––offer a predetermined interest rate. When inflation rises, the real return on these bonds (adjusted for inflation) decreases. Bondholders may find that the purchasing power of their interest payments and principal is diminished.

High interest rate risk

Inflation can lead to higher interest rates, which tend to have an inverse relationship with bond prices. When interest rates rise, the value of existing bonds with lower yields becomes less attractive, potentially resulting in capital losses for bondholders.

Impact on real estate

Increased costs

Inflation often leads to high construction costs, property maintenance expenses, and property taxes. Real estate investors sometimes face challenges to turn a profit as costs rise and keep rising.

Rent and lease agreements

Real estate owners who receive rental income may find it challenging to adjust lease agreements to keep pace with inflation. This can lead to reduced “real” rental income over time.

Property value fluctuations

Inflation can significantly impact the value of real estate investments. While real estate is often considered a hedge against inflation, rising interest rates associated with inflation can affect property values.

Investment strategies to mitigate inflation risk with Composer

Now that we’ve covered why inflation is a critical consideration for investors, it’s time to leverage cutting-edge tools to help you mitigate the risk. Enter Composer. Here are a few strategies to help you:  

Invest in inflation-protected securities

Treasury Inflation-Protected Securities (TIPS) are U.S. government bonds specifically designed to protect against inflation. Their principal value adjusts with changes in the Consumer Price Index (CPI), ensuring bondholders receive returns that keep pace with inflation. You can consider using convenient TIPs ETFs to take advantage.

Consider commodities

Commodities––such as gold, oil, and agricultural products––often perform well during inflationary periods. Via commodity ETFs like BCI and ACQ, Composer helps investors incorporate commodities into their portfolios to serve as a hedge against rising prices.

Diversify portfolio 

Spread risk and mitigate inflation’s impact by diversifying your investment portfolio. Composer offers tools and strategies to invest in a mix of asset classes, including stocks, bonds, real estate, and commodities.

Monitor and adjust

Composer's monitoring and analysis tools allow investors to stay informed about inflation trends and make informed adjustments to their investment strategies as needed.

Composer offers tools to help you mitigate inflation risks

Composer is your trusted ally in navigating the volatile economy of the 21st century. With Composer's sophisticated tools and features, you can proactively identify and implement strategies to counteract the eroding effects of inflation. 

Whether you’re looking to invest in TIPS, diversify into commodities, or adjust your portfolio to adapt to inflation risk, Composer offers the solutions you need to solutions you need to tackle the effects of inflation.

Don't let inflation silently eat away at your investments. Explore Composer's innovative toolkit and empower yourself to make more informed and confident decisions. Sign up for a free 14-day trial today.