Inflation represents the extent to which prices for goods and service increase over time and erode the purchasing power of your hard-earned dollars. Central banks, such as our Federal Reserve, across the world spend much time worrying about keeping inflation in a tight range as both deflation and inflation can be bad for business and economies. A concern these days is that interest rates are too low and will encourage an unnecessarily rapid economic recovery that will eventually stoke inflation.
Good and Bad Investments During Inflation
Here are some ways to whip inflation if you are worried how it might impact your finances. For starters, gold is considered a hedge to inflation and even though its value is reaching all-time highs, it will likely keep rising along with inflation fears and if/when it actually occurs. Hard assets such as real estate and commodities are also seen as secure investments during inflation because they represent physical assets that are ‘real’ and whose value can’t be easily eroded.
Government and municipal bonds are not the assets to hold as inflation eats away at their returns. Treasury inflation protected securities, or TIPS, have a variable interest rate component meant to rise when inflation (which is measured by the Consumer Price Index (CPI)) does, so consider these in your portfolio. They key metric when investing in bonds is real interest rates, which subtract out the negative impact of inflation on returns. Stocks can also protect against inflation provided you invest in firms that are able to pass along higher prices to their customers and protect their profits.
Your own salary is perhaps the best inflation hedge as companies habitually award annual cost-of-living adjustments to protect the purchasing power of your salary. For self employed small business owners, pricing power is key so that goods and services can rise along with inflation. In one sense, inflation means rising costs, so with moderate levels of inflation keeping costs minimized is also important. All bets are off when hyperinflation rears its ugly head and has occurred in countries such as Brazil in the 1980s. Fortunately, hyperinflation is rare in developed countries such as the U.S.