Inflation implies to a rise in the average cost of goods and services over a certain period of time. It is measured by the Bureau of Labor Statistics, which compiles data to determine the Consumer Price Index (CPI). The normal range of inflation in the United States is 2-3% but the cost of living as measured by the CPI rose 6.2% in 2022. This meant that the overall prices increased by 6.2% for the year. As per Kavan Choksi Professional Investor points out, the demand and supply also have a vital role in inflation. Prices typically go up as the demand for certain services or goods goes up or its supply goes down.
Kavan Choksi Professional Investor briefly discusses how inflation impacts savings and investments
To orderly understand how inflation can hamper investment returns one must learn to differentiate between nominal and real interest rates. Basically, the nominal interest rate is the rate of interest without any adjustment for inflation, and one would earn this interest rate only if inflation was zero. On the other hand, the real interest rate is the nominal interest rate minus the rate of inflation. This interest rate accounts for inflation, and shows the actual gain or loss in purchasing power.
Nominal interest rates must outpace inflation or at least keep up with it for an investor to earn a real return. This essentially means that investments with lower interest rates are generally hit harder by the effects of inflation. During inflation, cash and cash equivalents receive the biggest blow. After all, if there is no interest being generated to compete with the rate of inflation, it may rapidly eat into the purchasing power of the cash.
Inflation may additionally shrink the savings of a person even if they have secured their funds in a savings account with an average interest rate. For instance, inflation can impact how much the retirement savings of a person is worth. In theory, when a person is working, their monthly earnings should ideally keep pace with inflation. But if a person is living off their savings, inflation can diminish their purchasing power. It is vital for people to orderly monitor their savings against inflation to see to it that they have enough assets to last through the retirement years.
As Kavan Choksi Professional Investor mentions, inflation can considerably lower the real returns on fixed income investments of a person, like corporate or municipal bonds, treasuries, and more. Typically investors purchase fixed income securities with the aim of enjoying a steady income stream in the form of interest payments. But as this income stream remains the same on most fixed income securities until maturity, the purchasing power of the interest payments goes down as inflation surges. Hence, bond prices fall as inflation increases.
When it comes to stock investments, value stocks usually perform better than growth stocks when inflation is high. Value stocks belong to companies that investors think are undervalued by the market, while growth stocks imply to the companies that investors think will deliver better-than-average returns.