How does inflation impact investments?

Inflation is continuing to be a hot topic with investors, and it’s not hard to imagine why. It can be a powerful force affecting our daily lives and economic growth and potentially impacting investments.

So how does inflation work, and why does it affect investments?

What is inflation?

Inflation is measured as a percentage and is the rate at which the price of goods and services rises. So, if inflation is 5%, that means that goods and services would cost you 5% more today compared to a year ago. As inflation rises, the purchasing power of your money decreases, meaning you can buy less with the same amount of money.

In Estonia, inflation is measured by the Consumer Price Index (CPI), published by Statistics Estonia. The consumer price index reflects the consumption structure of Estonian residents, whilst the harmonised index also takes tourists into account and is comparable to the international harmonised index of consumer prices (HICP).

CPI is calculated by measuring a basket of goods and services and comparing the cost against the price of that same basket a year ago. As inflation starts to impact and prices rise, you can do less with your money, as it doesn’t go as far.

The rate is managed by Eesti Pank, which works with the other central banks of the euro area in taking monetary policy decisions, though it must consider the state of the euro area as a whole. Eesti Pank also regularly advises the Republic government on crucial economic policy points. The central bank primarily helps assess and describe the impact of different policy choices on the economy.

How does the banks’ fiscal policy impact inflation?

The European Central Bank’s monetary policy target is to keep average consumer price inflation in the euro area close to 2% by managing interest rates. If a country’s economy and consequently its inflation rate deviate from the average, that difference can be smoothed with national economic policies, especially fiscal or budget policy.

Governments can use a well-targeted fiscal policy to smooth sharp changes in the economy by supporting the economy with additional spending during hard times and by spending less or building up reserves when the economy is growing fast. The government affects economic activity in the country through how much it takes money, with one hand through taxation. It puts it back into the economy, with the other hand through state budget spending on civil servants’ salaries, road building, or other expenses.

If the government spends more money than it receives from taxes and other forms of income, there is a budget deficit, and the additional money poured into the economy boosts demand and raises prices.

How the money injected into the economy affects inflation depends on the state of the economy at that point in time. Using a budget deficit to revive an economy during a downturn may not cause prices to rise, as some production capacity may otherwise have stood idle without that support.

If the economy is doing well and the private sector is running at full capacity, spending additional money through the state budget can have an inflationary impact. This is because production volumes may prove unable to increase at the same rate as demand if the existing production capacity is fully employed. The result is that there are not enough goods on sale to satisfy the demand to buy them, so prices rise.

Who can control inflation and how do prices factor in?

The European Central Bank can use monetary policy to steer inflation in the euro area through interest rates and the amount of money circulating in the economy.

The Estonian government can rein in inflation through the state budgets by spending less and building up reserves while the economy is growing fast and doing the opposite when it is performing poorly.

How does inflation affect investments?

If you’re investing in funds, inflation can impact the value of your investments. The inflation rate can significantly influence the actual returns on your investments. But the impact doesn’t mean it’s all bad.

A fund that invests in fixed-income investments, like bonds, can be particularly vulnerable to the effects of inflation.

When inflation is high, the fixed payments that investors get in the future from bonds (called ‘coupons’) are worth less in real terms. If a bond pays an annual interest rate that is lower than inflation, the real return on the bond is negative.

Investors may also shy away from bonds if banks raise interest rates to curb inflation. When interest rates rise, the yield on new bonds increases. This makes existing bonds with lower yields less attractive to investors, decreasing their value.

But don’t lose hope!

Inflation can also positively impact investments. Despite higher costs, some companies are better equipped at managing inflation than others. As prices rise, the profits of some companies may increase, which should improve their share price. That means some funds that invest in equities could benefit from inflation. Given time, investing in equities can be a way to buffer against inflation.

If all this talk about bonds and equities boggles your brain, our handy jargon buster can help.

12 investment strategies for managing inflation risk

Managing inflation risk is crucial for protecting the value of your investments over time. Here are some investment strategies to consider:

1. Understand your investments: If you like to invest and let it do its thing, there’s no problem. Understanding your portfolio doesn’t mean being immersed in the details unless you want to be. It won’t take long to look at what you’re investing in. This can help you understand why your investments do what they do in response to inflation. Understanding your investments also means knowing the economic policies that can affect inflation and your portfolio.
2. Diversify your portfolio: A diversified investment portfolio can help manage inflation risk. By spreading your investments across various asset classes, you can reduce the impact of inflation on your overall portfolio. You can also try copy trading if you are unsure how to diversify your portfolio.
3. Invest in inflation-resilient assets: Certain assets tend to perform well during periods of inflation. Precious metals like gold and silver and real estate often retain their value or even appreciate when inflation rises. These can be valuable additions to your portfolio.
4. Consider inflation-indexed bonds: Inflation-indexed bonds, such as Treasury Inflation-Protected Securities (TIPS), are designed to hedge against inflation. These bonds adjust their principal value based on changes in the Consumer Price Index (CPI), ensuring that your investment keeps pace with rising prices.
5. Focus on companies with strong pricing power: Companies in the consumer staples sector often have strong pricing power, meaning they can pass on increased costs to consumers without significantly reducing product demand. Investing in such companies can help protect your portfolio from inflation.
6. Maintain a well-diversified portfolio: A mix of stocks, bonds, and alternative investments can help manage inflation risk. Diversification across different investment types, geographies and sectors can further reduce the impact of inflation on your investments. This can help you stay calm and continue when the markets are in flux.
7. Regular portfolio rebalancing: Regularly rebalancing your portfolio ensures that your investments align with your inflation management goals. This involves adjusting your asset allocation to maintain your desired level of risk and return.
8. Explore emerging markets: Investing in emerging markets can hedge against developed markets’ inflation. These markets often experience higher inflation rates, which can lead to higher investment returns.
9. Invest in commodities: Commodities like oil and gas can provide a hedge against inflation. As prices for these essential goods rise, the value of investments in these commodities can also increase.
10. Use inflation swaps and derivatives: Inflation swaps and other derivatives can be used to hedge against inflation risk. These financial instruments allow you to exchange fixed payments for payments that rise with inflation, protecting rising prices.
11. Adopt a long-term perspective: A long-term investment perspective can help you ride out periods of inflation. By focusing on your long-term financial goals and maintaining a disciplined investment approach, you can better manage the impact of inflation on your portfolio.
12. Don’t try and time the market: It’s an old saying—buy when prices are low, sell when they’re high. But times have changed! Trying to time the market is like being a pilot on the ground waiting for sunshine on a rainy day so they can take off. You can waste time looking for a break in the clouds rather than being in them and still flying to your destination. Even if the weather isn’t ideal, you can still get to where you want to go. That’s the same for being invested in the market. It might not be without turbulence, but it’s better to be in it than to wait for the perfect time. Being in the market longer means you can weather its ups and downs.

Implementing these investment strategies can better protect your investments from the effects of inflation and ensure that your portfolio remains resilient to rising inflation.

Remember, the value of investments can go up and down, so you may get back less money than you put in. Tax depends on your individual circumstances, and the regulations may change in the future.