By PIMCO
- Understanding inflation is crucial to investing because inflation can reduce the value of investment returns
- Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates, to government programs and interest rates
- The right fixed-interest investments can help to provide protection against inflation
What is inflation?
Inflation is a sustained rise in price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy. In the growth stage of an economic cycle, demand typically outstrips the supply of goods, and producers can raise their prices. As a result, the rate of inflation increases. An upward price spiral, sometimes called ‘runaway inflation’ or ‘hyperinflation’, can result. The inflation syndrome is often described as ‘too many dollars chasing too few goods.’ As spending outpaces the production of goods and services, the supply of dollars in an economy exceeds the amount needed for financial transactions. The result is the purchasing power of a dollar declines.
In general, when economic growth begins to slow, demand eases and the supply of goods increases relative to demand. At this point, the rate of inflation usually drops. Such a period of falling inflation is known as disinflation. Disinflation can also result from a concerted effort by a government and policy makers to control inflation. When prices actually fall, deflation has taken root. Often the result of prolonged weak demand, deflation can lead to recession and even depression. The longest and most severe period of deflation over the past century occurred in the 1920s and in the 1930s during the Great Depression.
How Is inflation measured?
When economists try to measure inflation, they generally focus on ‘core inflation’. Unlike the ‘headline’ or reported inflation, core inflation removes volatile components which can cause unwanted distortion to the headline figure. There are several regularly reported measures of inflation. The two most widely monitored indicators are: Producer Price Index (PPI) – the PPI measures prices paid to producers, usually by retailers; and, the Consumer Price Index (CPI) – the CPI reflects retail prices of goods and services, including housing costs, transportation, energy and healthcare.
Exchange rate movements can cause inflation. As a country’s currency depreciates, it becomes more expensive to buy imports, which puts upward pressure on prices overall. Over the long term, currencies of countries with higher inflation rates tend to depreciate relative to those with lower inflation. Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation.