For world economic markets, inflation is a fairly new experience as for much of the pre-twentieth century there had been little upward pressure on prices due to gold and other metallic standards. These backed currencies limited governments’ abilities to create new money. So at the end of the gold standard strong political pressures often caused governments to issue more money increasing the money supply and therefor the price level.
But what effect does inflation have on the economy and on investment in particular? Inflation causes many distortions in the economy. It hurts people who are retired and living on a fixed income. When prices rise these consumers cannot buy as much as they could previously. This discourages savings due to the fact that the money is worth more presently than in the future. This expectation reduces economic growth because the economy needs a certain level of savings to finance investments which boosts economic growth. Also, inflation makes it harder for businesses to plan for the future. It is very difficult to decide how much to produce, because businesses cannot predict the demand for their product at the higher prices they will have to charge in order to cover their costs. High inflation not only disrupts the operation of a nation's financial institutions and markets, it also discourages their integration with the rest of the worlds markets. Inflation causes uncertainty about future prices, interest rates, and exchange rates, and this in turn increases the risks among potential trade partners, discouraging trade. As far as commercial banking is concerned, it erodes the value of the depositor's savings as well as that of the bank's loans. The uncertainty associated with inflation increases the risk associated with the investment and production activity of firms and markets.
The impact inflation has on a portfolio depends on the type of securities held there. Investing only in stocks one may not have to worry about inflation. In the long run, a company’s revenue and earnings should increase at the same pace as inflation. But inflation can discourage investors by reducing their confidence in investments that take a long time to mature. The main problem with stocks and inflation is that a company's returns can be overstated. When there is high inflation, a company may look like it's doing a great job, when really inflation is the reason behind the growth. In addition to this, when analyzing the earnings of a firm, inflation can be problematic depending on what technique the company is uses to value its inventory.
The effect of inflation on investment occurs directly and indirectly. Inflation increases transactions and information costs, which directly inhibits economic development. For example, when inflation makes nominal values uncertain, investment planning becomes difficult. Individuals may be reluctant to enter into contracts when inflation cannot be predicted making relative prices uncertain. This reluctance to enter into contracts over time will inhibit investment which will affect economic growth. In this case inflation will inhibit investment and could result in financial recession(Hellerstein, 1997). In an inflationary environment intermediaries will be less eager to provide long-term financing for capital formation and growth. Both lenders and borrowers will also be less willing to enter long-term contracts. High inflation is often associated with financial repression as governments take actions to protect certain sectors of the economy. For example, interest rate ceilings are common in high inflation environments. Such controls lead to inefficient allocations of capital that inhibit economic growth(Morley, 1971).
The hardest hit from inflation falls on the fixed-income investors. For example, suppose one year ago an investor buys a $1,000 T-bill that yields 10%. When they collect the $1,100 owed to them, is their $100 (10%) return real? No, assuming inflation was positive for the year, the purchasing power of the investor has fallen and thus so has the real return. The amount inflation has taken out of the return has to be taken into account. If inflation was 4%, then the return is really 6%. By the Fisher equation (nominal interest rate – inflation rate = real interest rate) we see the difference between the nominal interest rate and the real interest rate. The nominal interest rate is the growth rate of the investors’ money, while the real interest rate is the growth of their purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. Here the nominal rate is 10% and the real rate is 6% (10% - 4% = 6%).
Inflation causes anxiety particularly for retirees who are uneasy about inflation adjustments to their pensions and financial investments. Planning for retirement requires expectations of future prices. Inflation makes this more difficult because even a series of small, unanticipated increases in the general price level can significantly erode the real value of savings over time. Social Security payments are now indexed to inflation, a policy change that has reduced the effects of inflation uncertainty on retirement.
There are securities that offer investors the guarantee that returns are not eaten up by inflation. Treasury Inflation-Protected Securities are a special type of Treasury note or bond that offers protection from inflation.
With a regular Treasury bond, interest payments are fixed, and only the principal fluctuates with the movement of interest rates. The yield on a regular bond incorporates investors' expectations for inflation. So at times of low inflation, yields are generally low, and they generally rise when inflation does. Treasury Inflation-Protected Securities are like any other Treasury bills, except that the principal and coupon payments are tied to the consumer price index (CPI) and increased to compensate for any inflation. As with other Treasury notes, when you buy an inflation-protected or inflation-indexed security, you receive interest payments every six months and a principal payment when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). Treasury Inflation-Protected Securities are the safest bonds in which to invest. This is because the real rate of return, which represents the growth of purchasing power, is guaranteed. The downside is that because of this safety and the lower risk, inflation-protected bonds offer a lower return.
Sustained inflation is damaging to long-run growth and the financial system in general. Increases in inflation lead to lower real returns not just on money, but on all other assets too. These low returns interfere with the functioning of financial markets and the allocation of investment. Lower real returns have the effect of severely damaging the credit market. As a result, higher inflation contracts the supply of credit available to fund capital investment damaging the economy(Blume, 1978).
It has been shown that inflation affects investment in several ways, mostly inhibiting economic growth. The source of inflation is money and the supply of it. Investors need to be able to expect returns in order for them to make financial decisions. If people cannot trust money then they are less likely to engage in business relationships. This results in lower investment, production and less socially positive interactions. Among other effects, people may start to attempt to trade by other, less efficient, means in order to avoid the unpredictable price levels due to inflation.
Blume, Marshall. Inflation and Capital Markets. Ballinger, Cambridge, 1978.
Hall, Robert ed. Inflation, Causes and Effects. University of Chicago Press, Chicago, 1982.
Hellerstein, Rebecca. “The Impact of Inflation,” Regional Review, Winter 1997, Vol. 7, No. 1.
Massimo, Caruso. “Investment and the Persistence of Price Uncertainty,” Research in economics, Vol. 55, June 2001.