Inflation: What is It and Why Does It Matter?

Investors and others in the business world have been on edge as of late due to volatility in the global economy and worldwide financial markets. Much of the anxiety among market participants stems from concerns over rising inflation around the world. Too much inflation in an economy can be highly detrimental and may even result in a recession. 

How do you define inflation? 

Economists, broadly speaking, define inflation as the phenomenon of the overall purchasing power of a specific currency, such as the dollar, experiencing a significant decline. This means your money’s ability to purchase goods and services is diminished during a particular period of time. Most economists will measure inflation in an economic region by observing price increases, expressed as a percentage, of a group of goods or services during a specific time period. 

Inflationary impacts 

The consequences of inflation can be seen in consumers’ decreasing ability to buy goods and services with the currency they are holding. This loss of purchasing ability can eventually result in falling consumer demand overall. When this occurs, you may see economic growth become significantly hampered. 

How central banks react to inflation 

In an effort to combat inflation central banks may take actions that constrain the money supply. The idea is that inflation is caused by the money supply growing faster than the growth of the economy. Essentially, central bank actions to combat inflation are meant to manage supply of currency as well as available credit. 

One potential action a central bank can take is to reduce the amount of bonds it purchases. A central bank can also hike bench market interest rates. 

How do governments deal with inflation? 

Central banks are not the only institutions that can help mitigate inflation in a nation’s economy. Governments are also able to take action to curb inflation. One option a government can implement is to increase taxes which will take money supply out of circulation throughout the economy. Also, constraints on supply chains can many times be addressed through government actions which can reduce input costs, ultimately reducing prices paid by consumers. 

What should investors do about inflation? 

There are several strategies investors may want to consider employing in order to deal with rising inflation. Some assets are negatively affected by inflation. These are the assets which investors should consider staying away from. For example, technology stocks, although providing significant growth potential in a healthy economy, are negatively affected by rising interest rates resulting from central bank actions to combat inflation. 

However, you should be aware of other types of assets which tend to do well in more inflationary economic environments. For instance, increasing interest rates can translate into increased income from debt instruments such as government bonds. Real estate and commodities also tend to do well during times of inflation. 

Speaking with a financial advisor 

Making the right investment decisions to rebalance your portfolio with increasing inflation in mind is essential to proper wealth management. This requires complete knowledge of how financial markets work and an accurate view on the economy. Having the assistance of a financial professional can be invaluable.

Opinions expressed are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Investing involves risk and investors may incur a profit or a loss regardless of strategy selected.