Inflation: what it is, and how to invest during inflationary times

As the impacts of inflation continue to ripple through the economy, rising prices have squeezed almost every budget, impacting everyone from the lowest earners to the highest. Once you know how inflation works, you can take steps to get ahead of it.

Inflation measures how fast the price of goods and services rises. During periods of inflation, a single dollar buys less than it used to, as the cost of everything from bread to rent increases. As a result, you may also see inflation defined as the loss of purchasing power over time.

Inflation doesn’t typically occur evenly in an economy. For instance, while the price of bread may double overnight, your rent probably won’t. Therefore, when you ask what is the inflation rate, you’re actually referring to the average price increase economy-wide.

Generally, this is measured by the Consumer Price Index (CPI), which tracks rising prices of consumer goods and services nationwide. Using the CPI means that consumers can see a single value that roughly represents how much more expensive life gets every year.

Note that some inflation is expected in modern economies, as it helps ensure continuous growth. It’s when inflation soars too quickly that consumers, investors, and businesses feel the pinch.

The reasons for inflation can occur simultaneously and often include:

• Supply for products and services decreases, leading to shortages

• Demand for products and services increases, leading to scarcities

• Production costs rise, leading to higher consumer costs

• Money supply increases, causing the value of each dollar to decrease (i.e. when central banks decrease rates and ease monetary conditions or governments print money by offering subsidies through spending and entitlement programs)

The causes of inflation are grouped into three categories: demand-pull effect, cost-push effect, and built-in inflation.

The demand-pull effect appears when consumer demand rises more than supply, pulling costs higher. For example, during the start of the COVID-19 pandemic, a surge in demand for personal protective equipment like masks and gloves put upward pressure on prices. Disruptions caused by pandemic lockdowns also led to decreased supply of goods and services, which could have led to higher prices.

The cost-push effect occurs when production costs rise, and these costs are passed to consumers. In cost-push inflation, demand for goods and services may stay the same, but the supply shrinks, forcing prices to increase. This can occur due to material shortages — such as less wheat or iron ore — or higher labor costs. In some cases, disasters like mine collapses, droughts, or hurricanes can impact production and spike prices.

Built-in inflation is a psychological reason for inflation. Essentially, once inflation begins, consumers and businesses may expect prices to continue rising. To compensate, workers demand higher wages, while consumers spend more to lock in low prices.

Together, these impacts could lead to a wage-price spiral that ensures prices continue rising because consumers expect them to. However, IMF data suggests that wage-price spirals are quite rare.

Though rising prices may mean tighter budgets if you don’t get a raise, inflation doesn’t have to be all bad. With the right financial maneuvers, you might even profit from inflation.

You’re more likely to benefit from inflation — or at least see fewer impacts — if you:

• Own or are paying off your own home, as you won’t be subjected to rent increases

• Currently have fixed-interest loans, as the relative cost of these debts decreases with inflation

• Invest in assets that benefit from inflation, such as real estate or commodities

• Invest in stocks in inflation-friendly industries like real estate, or industries that can easily pass higher costs to consumers like healthcare

• Invest in collectibles known for gaining value with inflation, including certain spirits, fine art, and vintage automobiles

While it’s possible to ease the effects of inflation, you can also easily fall prey to higher prices. Typically, you’re more likely to suffer from inflation if you:

• Earn a lower-than-average wage, as more of your income is already spent on necessities compared to high-income earners

• Are on a fixed income such as Social Security, and struggle to afford higher prices on everyday goods

• Keep most of your money in your checking or savings accounts, as inflation erodes your purchasing power

• Rent your home, as you’re subject to rent increases

• Need to make a large purchase — like a house, car, or even household appliances — that have become more expensive

• Have lent money at lower fixed interest rates than the current market rates, including buying long-term bonds

• Owe money on a variable-rate mortgage, credit card, or other loans that don’t have set interest rates

Investing during inflation can be tricky business. Even if you make the “right” investments, it's still possible that your portfolio won’t keep up with rising prices. If you’re looking for the best investments during inflation, here’s where to start.

Over long periods of time, real estate values tend to increase. Rental properties that generate cash flow usually outperform other investment assets in periods of inflation. Most real estate investors can raise rental prices to match the pace of inflation and secure income. In addition, with a decreasing value of the dollar, current debt on real estate assets becomes cheaper. It’s important to note that investing in real estate can be expensive and requires patience. Construction, maintenance, and upkeep costs will most certainly rise with inflation. If you’re considering buying a rental property, make sure you’re getting good value for your investment in the form of sustainable cash flow. You’ll also want to be prepared to navigate short-term market downturns that could impact profits.

If you don’t want to invest in physical properties, you may consider private or public market opportunities, like real estate-focused funds or real estate investment trusts (REITs). An experienced financial advisor can assist you with finding the best real estate investments.

If you want to know where to put money during inflation, another investment to consider is commodities. Commodities are a raw material or primary agricultural product that can be bought and sold. This wide-ranging asset class includes:

• Agricultural products (grain, beef, etc.)

• Raw metal ore (copper, iron, gold, or even uranium)

• Energy (fossil fuels, power, renewables, etc.)

Commodities prices can be particularly sensitive to economic growth, including inflation. As prices for raw materials rise, the cost of other goods and services goes up, too. If you invest at the ground level — such as in the raw goods themselves — you can profit off early supply-chain inflation.

Commodities as a whole are a volatile asset class, and it’s hard to predict which commodity will be in demand. Many common commodity vehicles, like futures contracts that derive their value from other financial assets, are considered advanced instruments that require more knowledge and capital to navigate. You can also diversify your commodity investments with mutual funds or exchange-traded funds.

Many experts recommend limiting commodity holdings to a small portion of your investments in order to limit downside risk. If you’re unsure about how to approach investing in commodities or how much, consider working with a financial advisor. FinanceHQ can help connect you with an advisor who can help you determine the right construction for your investment portfolio.

Generally, one risk-free way to combat inflation is through I bonds, one of the many different types of bonds. Treasury I bonds, or inflation bonds, provide a government-issued direct hedge against inflation. These unique vehicles generate interest that adjusts for inflation twice per year. In other words, as inflation rises, these fixed-income bonds kick out higher payments to compensate.

I bonds are an attractive choice if your goal is to meet inflation head-on. However, they come with some strict limitations: a $15,000 annual purchase limit — $10,000 in electronic bonds and $5,000 in paper bonds.

I bonds are fairly illiquid compared to some of the other investments on this list, and their interest rates can fluctuate or drop to zero.

Additionally, I bonds don’t make regular interest payments. Instead, you cash in on your accrued interest when you sell, and you have to wait at least one year to do so. Cashing out within the first five years also carries hefty interest penalties. Assuming you don’t cash in early, the bonds pay out when they mature 30 years after they’re issued.

Treasury Inflation-Protected Securities (TIPS) operate similarly to I bonds in that they adjust with inflation, but instead of adjusting your interest rate, the principal value of the bond changes, which is what you receive upon repayment.

In particular, TIPS are linked to the Consumer Price Index, so they directly rise and fall with official inflation numbers. Since bonds pay interest on the principal, a higher principal value means you earn more interest and vice versa.

TIPS offer a fantastic method to preserve the power of your dollars. However, as with I bonds, TIPS come with some downsides to consider. To start, TIPs don’t offer much growth – they’re pegged to inflation, and that’s it. Because they adjust for inflation, it’s possible that you’ll earn less in a low-inflation year.

Ultimately, the value you receive upon maturity may change. The maturity is the date of expiration which varies between 5, 10, and 30 years. Although the value you receive upon maturity will never fall below the security’s original par value, if you sell before maturity, you risk a loss if TIPS principal prices have fallen since your original investment.

For example, in 2022, TIPS prices have fallen more than the principal has adjusted higher, resulting in negative total returns for the year.

Gold is a tricky inflation hedge because its growth doesn’t always outpace inflation. Additionally, if you invest in physical gold, you’ll also have to consider insurance, storage, and premiums — all of which eat into your returns. Together, these factors make investing in gold for profit difficult.

Still, gold remains a common store of value when the purchasing power of a currency begins to decline. If you buy in at the right moment – or invest in gold-based funds that also see price appreciation – you can net some healthy returns during inflation.

Inflationary times make choosing appropriate investments even more difficult. Aside from the stress of finding assets that will generate long-term profits, you also have to beat short-term inflation, which can create added volatility.

If you’re not sure how to implement an inflation-adjusted portfolio strategy, working with a financial advisor is a great place to start. An experienced professional can steer you away from a “one-size-fits-all” approach with personalized advice that accounts for your wants, needs, and goals.