Inflation is a necessary evil that takes away our purchasing power but induces future growth. The current US inflation rates comparing 2020 to 2022 shows a four-fold increase in inflation to 8.5% by March 2022. Inflation is inconvenient if you hold liquid cash, pay home rent, have an adjustable mortgage, or buy consumer goods and services. It may give you a reason to consider securing a mortgage now or investing in inflation-hedged assets like gold, real estate, fixed-rate mortgages, TIPs, stock, and stable currencies to beat inflation. We need to consider the costs and benefits of inflation before making any investment decision. Here’s everything you need to know on how to avoid inflation.
What is inflation?
Inflation happens when the price of assets (goods and services) increases over a period of time. Let’s understand inflation through purchasing power. You could purchase eight eggs with $1 in 2010 but only four eggs with that same $1 in 2022. Though the nominal value of $1 remains constant, the amount of goods or services you can purchase with that $1 has now decreased. Inflation has decreased the purchasing power of the dollar during this period. It also pushes the price of fixed assets like real estate and stocks higher over the long term.
How is inflation measured?
Inflation is measured on a basket of goods and services to reflect the macro outlook of a particular sector. In the US, the Bureau of Labor Statistics (BLS) compiles the Consumer Price Index (CPI), which comprises thousands of goods and services like food, fuel, housing, medical care, apparel, transportation, entertainment, etc. that Americans buy every day. It is a weighted average, meaning that an increase in house prices will affect the index more than a similar increase in the price of eggs. Inflation is the percentage change in the CPI over a period of time.
How does inflation affect assets?
Inflation affects different asset classes differently. You will typically lose your purchasing power during inflation if you are invested in the following asset classes.
- Fixed interest rates
- Corporate/Treasury Bonds with yields lower than inflation
- Consumer backed equity
Conversely, you can gain long-term income during inflation if you are invested in the following asset classes.
- Real estate
- Commodity/Real estate-backed equity
- Adjustable interest rate deposits
- Fixed mortgages
Think of inflation as the process of decreasing the money supply from the system. Banks charge higher interest on loans and reduce deposit rates. This makes money dearer, and investors flock to buy safe assets with liquid cash, further driving up prices. For example, the value of a home and its mortgage rise simultaneously during inflation. While the owner pays a higher interest to the bank, he will charge a higher rent or quote a higher sale price to pass on the inflation costs to the end buyer. This process continues until there is no buyer for the peak rate/price.
How does inflation affect savings?
Inflation has a negative correlation with savings, meaning that you will lose the value of your savings during inflation. The difference between the deposit and inflation rates is the actual return on your savings. If you are getting an interest rate of 2% per annum and the inflation rate is 8%, you are losing 6% of your purchasing power annually. Even though you have the same nominal value of cash in your savings account, you will be able to purchase 6% fewer goods/services after one year.
How does inflation affect debts like loans?
The interest rates on loans rise during inflation. Usually, this is balanced by a similar increase in earnings. Working professionals can take additional credit at a higher rate because inflation leads to higher wages. Businessmen can take small business loans at higher interest to offset rising costs during inflation, which can be further charged from the end consumer.
However, inflation can add weight to your existing liabilities when there is no growth in earnings. Analysts believe that we may pay more taxes during inflation even when the IRS adjusts some tax brackets based on inflation. You can benefit by paying off your tax liabilities early at the start of inflation. Students with variable interest student loans can refinance to a fixed-rate plan during inflation to hedge against rising interest rates.
How does inflation affect personal loans?
Inflation affects both borrowers and lenders depending on the circumstances. Borrowers who have borrowed or refinanced at fixed interest rates on their personal loans can benefit during high inflation. They can benefit from rising wages but still, pay a fixed interest on their credit. Similarly, you can benefit from taking an adjustable interest debt just at the peak of inflation as interest rates decrease during deflation. Lenders usually benefit from providing adjustable-rate loans during high inflation and fixed-rate loans during deflation.
How does investing help you beat inflation?
Any economic cycle goes through phases of money supply accumulation and distribution. Imagine a pullback car as the economy. For the car to move forward, it needs to be pulled back, during which potential energy is accumulated inside its clockwork motors. You can analogize this phase to inflation, where the money supply comes back to banks, real estate, gold, etc., and consumer spending decreases. You should convert liquid assets to long-term inflation-hedged assets during this phase. Understanding the investment opportunities in inflation will help you understand how investing can help you beat inflation.
How to invest during inflation
You can profit from inflation in the long term with well-timed borrowings and investments. A perfect example would be if you bought a house in 2015 with a fixed interest mortgage (when house prices and interest rates were low) and sold the house to pay off the debt in 2022 (when house prices and interest rates are high). You not only profited from the sale of the house but also notionally by paying fixed interest while rates rose.
Inflation is the best time to liquidate your low-interest deposits and use your savings to purchase long-term assets like real estate or gold. You can regularly invest in real-estate-backed equity or gold bonds with your disposable income. You can also seek credit at fixed rates to finance long-term investments in some cases.
Short Term Investments
You may invest for the short term in commodities like precious metals, agricultural produce, energy, etc. since their prices increase during inflation. You can buy/sell futures contracts on commodities through investment apps. You can also invest in the stock market for short-term investments. Equity and ETFs in real-estate or commodity-backed companies tend to do well during inflation.
Long Term Investments
The best long-term hedge against inflation is real-estate. If you can get a good deal on a house and a fixed-rate mortgage when inflation is rising, you may profit in the long run on the investment. You can also diversify your long-term real-estate investments by buying shares of Real Estate Investment Trusts (REITs), which are companies holding a pool of real estate properties. They are classified into retail, mortgage, office, healthcare, and residential.
Treasury Inflation-Protected Securities (TIPS)
You can buy Treasury Inflation-Protected Securities (TIPS), which are government bonds that are indexed to inflation. Whenever the Consumer Price Index (CPI) rises, the bonds are marked higher to adjust for inflation. However, TIPS provides lower yields than traditional bonds and is subject to wild volatility swings.
What about gold?
Gold is the most trusted hedge against inflation. It is used as a global store of value, and its price follows an uptrend over the long term. Being cheaper than most other long-term assets, you can buy it regularly during high inflation. You can also invest in gold ETFs for some extra edge or gold bonds that pay out interest regularly.
Should you worry about inflation?
Inflation is not a bad thing but simply a phase in the economic cycle. As a consumer, you may worry about inflation. However, inflation provides you with excellent long-term opportunities as an investor. You may benefit from liquidating all fixed-income assets providing rates below the current inflation. You can then hedge your savings by investing in more productive sectors of the economy through instruments like stocks, futures, ETFs, bonds, precious metals, cryptocurrency, etc. Each category carries varying levels of risks and rewards. Understand your risk appetite before making investments, and you can easily navigate through inflation without worry.