Inflation, and what it does to money

Inflation is the most consequential economic variable for a saver, and the one whose effect is least visible because the numbers on the statement do not fall.

What it is

A sustained increase in the general price level, which is a decrease in the purchasing power of money.

Measured by tracking the price of a basket of goods and services over time.

Different measures exist within most countries — consumer price indices with and without housing costs, producer prices, and core measures excluding volatile items — and they can give materially different figures.

Which means citing an inflation rate requires knowing which measure and which basket.

The measurement problems

Which are genuine and technical.

Substitution: consumers switch away from goods that become expensive, which a fixed basket does not capture.

Quality change: goods improve over time, and separating price increases from quality improvements is difficult.

New goods entering the basket.

Housing costs, which are treated differently between measures and which are a large share of household spending.

And the fact that any average conceals enormous variation — inflation experienced by a household depends on what it buys, and lower-income households frequently experience higher effective inflation because energy and food form a larger share of their spending.

The effect on cash

The core point for savers.

Cash earning less than inflation loses purchasing power, which is a real loss despite the nominal balance being stable.

Compounded over decades this is substantial.

Which is the argument for investing money with long horizons rather than holding it in cash.

And equally, for holding short-horizon money in cash, since the certainty of the nominal amount matters more over a short period than the erosion.

The effect on asset classes

Which differs.

Conventional bonds are hurt by unexpected inflation, since their fixed payments are worth less and since central banks typically raise rates in response, reducing bond prices.

Inflation-linked bonds provide protection against unexpected inflation, while retaining sensitivity to real interest rates.

Equities have historically provided long-run protection against inflation, since companies can raise prices — though the short-run relationship is unreliable and high inflation periods have been poor for equities.

Property has some inflation-linkage through rents.

Commodities and gold are frequently cited as inflation hedges, with a historical record that is more mixed than the claim suggests.

And cash keeps pace only if rates rise with inflation, which they may do with a lag.

Real versus nominal

The distinction that matters for planning.

Nominal returns are what is reported; real returns are what remain after inflation.

A portfolio returning a positive nominal figure during a period of higher inflation has lost purchasing power.

Which means retirement and long-term planning should be done in real terms, and projections quoting nominal figures over decades substantially overstate what the money will buy.

Salary increases below inflation are real-terms pay cuts, which is the same arithmetic applied to income.

Why central banks target it

Briefly.

Most central banks target a low positive inflation rate, commonly around two per cent, on the grounds that stable low inflation supports economic decision-making.

Deflation is considered dangerous because it encourages deferral of spending and increases the real burden of debt.

The main tool is interest rates, raised to reduce demand and lower inflation, and lowered to do the reverse.

The effect operates with a lag of many months, which is why policy frequently appears to be responding to conditions that have already changed.

The recent experience

Worth noting without over-interpreting.

The period following the pandemic saw inflation rise substantially in many economies for the first time in decades, driven by a combination of supply disruption, energy prices and demand factors, with the relative contribution still debated.

Central banks raised rates sharply in response.

Which produced simultaneous falls in bonds and equities, undermining the diversification relationship that many portfolios relied on.

The lesson is not that the relationship never works but that it is conditional, which is a useful thing for any investor to have observed.

What to do about it

Practical.

Hold long-horizon money in assets with a reasonable prospect of exceeding inflation.

Hold short-horizon money in cash and accept the erosion, since the alternative risk is worse.

Consider inflation-linked instruments for long-dated real liabilities.

Plan in real terms rather than nominal.

Recognise that fixed nominal incomes, including some annuities, lose value over a long retirement.

And review savings rates, since cash rates lag inflation and providers rely on inertia.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.