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This article was originally published on April 12, 2021 and updated July 13, 2022.
While inflation is a normal part of a functioning economy, extreme inflationary conditions can have negative consequences across the spectrum, from businesses to individuals, from the most to the least experienced investors.
Inflation risk is never far from an investor’s mind, and there’s a lot that thoughtful investors can do to protect their assets—what’s known as “hedging” against inflation.
This article gives a basic introduction to inflation, how it works, and how it’s measured and managed within the U.S. economy before diving into common methods of hedging against inflation for long term portfolio stability.
- What Is Inflation?
- What Causes Inflation?
- How Is Inflation Measured?
- When Is Inflation Risky?
- How to Hedge Against Inflation
What Is Inflation?
Put simply, inflation is a general rise in prices over time.
This doesn’t mean the price of any one particular good or service. Rather, it indicates an average of a broad set—a “basket,” as the Bureau of Labor Statistics terms it—of prices of common goods and services within an economy. Inflation measures serve as a good indicator of how much people are paying for everyday necessities.
Because national and even global economies are interconnected, prices tend to rise or fall all together over time. That’s inflation.
For example, in 1900, the average cost of an acre of agricultural land was $20. One hundred years later, that number was $1,050, an increase of more than 52 times.
If this shift happened overnight, or if land was the only thing that rose so sharply in price, it would be a pretty shocking anomaly. But over such a long timespan, most assets and goods have generally increased in price at the same time (though not at the same rate). For reference, the average household income in 1900 was $450 a year.
What Causes Inflation?
Countless factors, such as supply of and demand for raw goods, globalization and technological advancement, and monetary policy, drive prices and influence inflation. Economists have several theories about how inflation actually happens, but they all describe the same basic cycle.
- Demand-pull inflation is the idea that an increase in available money and credit create more demand for goods and services. That demand outpaces the economy’s production, and prices rise in response.
- Cost-push inflation is a scenario wherein businesses’ costs of production rise, and down-market prices rise to keep up. Demand stays level, however, and now goods are less affordable for consumers.
- Built-in inflation happens when people expect inflation to continue pushing costs up, so workers demand higher wages in order to keep pace. This leads to what’s known as a wage-price spiral—a spiral that travels, you guessed it, upward.
How Is Inflation Measured?
The most common inflation measure you see in the United States is CPI, or Consumer Price Index, which measures the change in basic cost of living. It indexes the price of everyday consumer goods like bread and milk, as well as common costs like municipal water bills and sales tax.
You’ll typically see CPI numbers as percentages, representing the change in inflation over 12 months. In February of 2021, for example, that percentage was 1.7, meaning the price index had risen 1.7% since February 2020.
The other most frequently referenced metric in the U.S. is the Producer Price Index, or PPI. It looks at inflation through a business lens, averaging the change in selling prices for goods and services within an economy. PPI figures work the same way as CPI. In February 2021, PPI was up 2.8% from February 2020.
When Is Inflation Risky?
By setting interest rates and using other controls, the Federal Reserve aims for a 2% inflation rate over time. This is where we historically have seen optimum price stability and employment. Generally speaking, a slow, steady increase in inflation is thought to signal a healthy economy.
Inflation becomes problematic when it gets out of balance with other economic indicators, such as real wages. When growth doesn't keep up with the price of goods, currency’s purchasing power deteriorates.
There may still be plenty of money within the economy, but it won’t buy as much as before. The money supply exceeds people’s ability to spend it, prices keep rising to make up the difference, and inflation can start getting out of control.
For U.S. investors, as inflation erodes the future purchasing power of each dollar, financial assets are prone to depreciation brought about by changes in the value of money. Investments that previously produced a strong return may end up delivering a negative return once adjusted for inflation.
Additionally, as a result of inflation, consumers may find themselves with less discretionary income to invest or save. This can have a major impact on liquid investments like stocks, cash, savings accounts, etc. because rather than saving or investing, consumers need that money to afford the higher cost of living.
Real trouble arises when inflation builds its own momentum, leading to:
- hyperinflation, which is a condition in which inflation runs wild and continues to accelerate or
- stagflation, in which high inflation is accompanied by slow economic growth and high unemployment rates. In both these conditions, people’s purchasing power is catastrophically reduced, and it’s hard to turn the trend around.
How to Hedge Against Inflation
Once upon a time, hedges worked as fences, keeping livestock in and predators out. Applied to investments, hedging is an attempt to protect the value of your investments through various methods.
Two main principles of inflation hedging are
- portfolio diversification and
- allocating to inflation-resistant assets.
Firstly, maintaining a diverse portfolio is an essential principle of investing in all economic conditions. The basic idea is to own different kinds of assets so that your risk is spread out across asset classes. Ideally, your total investment portfolio stays healthy even as particular segments experience natural ups and downs.
Assets to Buy to Resist Inflation
Secondly, many investors prepare for potential inflationary conditions by specifically allocating a portion of their portfolio to inflation-resistant assets, such as:
- TIPS, or Treasury Inflation-Protected Securities,
- stocks, especially preferred stock or stocks in blue chip companies,
- international investments,
- real estate (such as agricultural land),
- precious metals,
- funds that track commodities or real estate, and
- floating rate bonds or bond funds.
- Inflation happens when the average price of goods and services increases rapidly.
- While a certain level of inflation is good for a healthy economy, too much or too quick of a rise can spell trouble for the value of investors’ assets.
- Investors can build resilience by maintaining a well-diversified portfolio that contains assets known to be resistant to inflationary pressures.
It’s important for investors and savers to be aware of the possibility of inflation and take measures to counteract it. Learn why investors are increasingly turning to land as a portfolio diversifier and a hedge against inflation.
Please note that AcreTrader is not a registered investment adviser. This article is intended to be used for educational purposes only and in no way constitutes investment advice or a recommendation to invest in any securities or other assets. All investments involve risk and could result in loss.