Inflation made simple
Investors live in fear of inflation. They are afraid of currency devaluation and uncontrollable equity markets. However, is there any justification to referring to inflation as a specter? What do terms such as inflation, deflation, and real interest rate mean? Inflation made simple.
Inflation is the general increase in prices for goods and services. This price increase means that the purchasing power of consumers is diminishing, i.e. you will not be able to afford as much as before with the same amount of cash.
Inflation is calculated on the basis of a price index, for example the Swiss Consumer Price Index (CPI), which maps the change in price of a shopping basket over a set period of time. The range of services and products in the shopping basket represents the needs of private households. These include "food and non-alcoholic beverages," "housing and energy," and "leisure and culture." Each of the cost pillars is weighted differently for the calculation.
The origins of inflation can be traced back to factors surrounding supply and demand, i.e. it can be caused in situations in which the demand for products and services outweighs the available supply. If the supply cannot be increased in the short term, companies will react by gradually increasing prices.
Inflation can also occur when the production of goods becomes more expensive – for example, because raw materials cost more or salaries rise. This also results in the prices of goods and services increasing.
1. Currency devaluation
As the general level of prices rises, households can afford less for the same amount of money. Inflation thus devalues money, which results in a drop in purchasing power.
2. A slowdown in economic growth
A reduction of the population's purchasing power would also impact business: If demand falls in the long term, companies will cover their costs by raising prices. Moreover, financial bottlenecks are likely to lead to fewer investments, which in turn slows economic growth.
3. Investments lose value
Inflation also affects investments via the real interest rate, which is the inflation-adjusted or deflation-adjusted nominal interest rate and thus takes into account purchasing power. If the inflation rate ever exceeds the nominal interest rate, the real interest rate will turn negative – i.e. savings in accounts will lose value.
Real interest rate = nominal interest rate – inflation rate
Account balance: CHF 10,000
Nominal interest rate = 2%
Inflation rate = 3.5%
Real interest rate = 2% – 3.5% = -1.5%
Effective value of the investment taking inflation into account:
10,000*(1-0.015) = CHF 9,850
Inflation is better than deflation
Politics and businesses prefer slight inflation. For example, the Fed is aiming for an inflation rate of 2% to ensure a healthy economy. This is because inflation generates growth: When companies anticipate an increase in prices, they invest and are able to pay higher salaries. As a result, consumers buy more.
Furthermore, slight inflation protects against deflation, which could block economic growth and even lead to an economic crisis.
Central banks control inflation with the prime rates
In respect of the impact on economic growth, central banks strive to maintain a stable rate of inflation. This is achieved by managing interest rates:
If inflation is lower than desired, central banks lower prime rates. As a result, companies are able to secure loans with more favorable conditions, and investments become more attractive. This stimulates economic growth, which in turn has a positive effect on consumer sentiment and increases inflation.
In contrast, if inflation is at risk of spinning out of control, central banks increase their prime rates. This also leads to interest rates on loans rising, which curbs corporate investment and the spending of private individuals. A drop in demand reduces inflation.
Impact of inflation on the stock market
In the financial markets too, inflation and especially rising prime rates are not without consequences. For equities, it is crucial to know how high inflation is. Moderate inflation, which goes hand in hand with healthy economic growth, supports equity price development. Inflation can cause uncertainty on the stock market, including panicking sales, and have a negative impact on the value of equities.
For bonds, the picture is in two parts. Their development is driven less by inflation than the development of prime rates. For instance, existing bonds in the portfolio lose value as soon as higher interest is offered for newly issued bonds. In contrast, those who invest in newly issued bonds at the right time benefit from higher interest for the entire term.