Inflation tells you how much the value of a dollar has changed over time. When inflation increases, the price of goods and services also increases. This can affect the economy in many ways, as well as your investments.
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What is inflation?
Inflation is the rate of increase in prices over time and relates to the purchasing power of money. With inflation, the same amount of money will buy fewer goods and services over time. Prices can change for various reasons, such as supply and demand for goods and services. The opposite is deflation, which is a period of price declines.
Inflation is usually described as a broad measure of price change across the economy. The Bank of Canada aims to keep inflation between 1 to 3% annually. The actual rate of price changes will be different across various goods and services.
In Canada, inflation shows the year-over-year increase in the consumer price index (CPI). It tracks the cost of a basket of 600 goods and services, including housing, transportation, furniture, clothing and recreation. CPI is a measure of the cost of living for Canadian households.
Use this calculator from the Bank of Canada to compare costs over time.
What is your real rate of return?
When you invest, you can make a profit if your investment increases in value. Or, you may take a loss if your investment declines in value. Your rate of return tells you how much your investments have gained or lost over time.
For example, imagine you had an investment worth $10,000. One year later, it was worth $11,000. Your nominal rate of return would be $1,000 — or 10% of your original investment. The nominal rate of return does not factor in expenses like investment fees, taxes and inflation.
Your real rate of return accounts for the impact of inflation. In the previous example, if the inflation rate was 5% over the year, then your real rate of return would be 5% (instead of 10% in the nominal rate of return example). This would mean you would make $500, accounting for inflation.
You can also factor investment fees and taxes into your real rate of return. Your real rate of return adjusts for inflation and other costs like these. It gives you a better sense of the purchasing power of the money you make from your investments.
How do inflation changes affect your investments?
Inflation can affect your investments, and the markets in general, in several ways. As costs increase, the purchasing power of your dollar declines. The real rate of return on your investments becomes less than it was. That means you’ll need to save more money over the long term to reach your goals. And you may need to look for a higher rate of return on your investments, which means taking on more risk.
An increase in consumer prices can also affect companies’ sales and reduce profits. This could cause some companies to reduce the dividends they pay to shareholders. Or, if certain industries are hit harder by inflation and struggle to turn a profit, then investments in these industries could also decline in value.
The stock market can fluctuate significantly during times of high inflation. As companies are negatively affected by the higher cost of borrowing and are dealing with decreasing consumer demand, this can dampen their earnings and lower their stock prices. Learn more about market volatility.
How does inflation affect interest rates?
Periods of high inflation can result in higher interest rates. The Bank of Canada and other central banks around the world may raise interest rates to slow down inflation.
An interest rate is the amount a lender charges as a percentage of the total amount borrowed. In other words the interest rate is the cost of borrowing. It’s usually expressed as the annual percentage rate (APR). Higher interest rates generally limit the amount of money people can afford to borrow and may even discourage some people from borrowing at all.
When the cost of borrowing changes, this can have a ripple effect on both borrowing and spending. This in turn can affect demand for goods and services, how people and businesses borrow and spend money, and how they invest.
For example, changes in inflation can affect bond prices. Interest rates and bond prices generally move in opposite directions — when inflation is on the rise, bond prices fall. That means, when your bond matures, the return you’ve earned on your investment will be worth less in today’s dollars.
Changes in interest rates can also affect the price of investments like real estate, where borrowing money is usually involved in the purchase — in this case, a mortgage. When interest rates change, so does the cost of borrowing money.
How can you manage inflation risk?
Inflation risk is the risk that the value of your investments will not keep up with increases in inflation. If the purchasing power of your money declines, you may need a higher investment return to meet your investment goals. There are a few ways to mitigate this kind of risk.
Investing in stocks is sometimes considered a hedge against inflation. That’s because stock prices often rise in line with inflation over the long term. However, inflation can affect different stocks in different ways. The rising price of goods and services creates uncertainty in the markets. This increases volatility and risk, which affects companies’ profit and growth. Some shares may perform better when inflation is high, and others may not. Remember that investing in stocks is often a long-term investing strategy, while inflation shocks can happen quickly over the short term.
There is no single way to manage inflation risk. But keep in mind different investments can behave differently during times of inflation. Having a diversified portfolio can help offset risk. This means investing in a mix of investments across different asset classes, with different risk profiles, such as equities, fixed-income investments (such as bonds), and cash or cash-equivalents (such as GICs).
What is stagflation?
If there is a period of stagnant economic growth, high inflation and rising unemployment it’s called stagflation. The term merges the words stagnation and inflation.
Central banks use interest rates as a tool to manage inflation. If economic growth is too high, raising interest rates can cool the economy and eventually lower inflation. Slower economic growth tends to be accompanied by lower employment and can potentially lead to a recession. However, if slower economic conditions are persistent and accompanied by higher inflation instead of lower inflation, this is what is referred to as stagflation.
Stagflation is an unusual economic condition. There is no single way to respond to stagflation as an investor. It’s important to consider your time horizon and level of risk tolerance. And consider getting advice if you’re not sure how to respond to challenging market conditions.
Summary
Inflation affects many aspects of the economy, including your investments. Keep in mind:
- Inflation tells you how much prices have changed over time.
- Inflation relates to the purchasing power of your dollar. As inflation increases over time, the same amount of money will have less buying power.
- Inflation reduces your rate of return on investments.
- Stock prices can fluctuate as companies absorb inflation shocks.
- Rising inflation can also result in rising interest rates.
- Changing interest rates can affect investments like bonds and real estate.
- You can mitigate inflation risks by diversifying your portfolio and considering long-term investing strategies. However, there is no single way to manage inflation risk.
