How Does Inflation Affect Investments?
You already know how inflation hits your pockets every time you go to the grocery store or fill up on gas, but how does inflation affect investments? We take a look at what inflation is and how it affects your money, wherever you keep it.
WHAT IS INFLATION?
Put simply, inflation is a decline in the real value of the money in your pocket. As a consumer, you experience inflation when your purchasing power declines because the prices of goods and services rise faster than you are able to increase your income. Inflation is measured as a percentage increase in prices over time relative to available income.
Inflation in the economy is measured in several ways. But the most typical one is to compare how prices for a standard “basket” of common store-bought items change from month to month. This is known as the Consumer Price Index.
WHAT CAUSES INFLATION?
Inflation is caused by the supply and demand for goods and services in the economy getting out of balance. This can happen when outside factors disrupt the availability of goods, especially things like gas or basic foodstuffs. When manufacturers and suppliers pay more to buy and transport raw materials, they end up passing this extra cost onto customers, spreading inflation.
Once prices have risen, it’s hard to get them down again. This means that raising income or increasing benefits to workers to help them cope with higher prices can end up stoking more inflation as demand outstrips supply and suppliers realize they can charge more, triggering an inflationary spiral.
While a small amount of inflation over time allows companies and the overall economy to grow, runaway inflation can be very hard to contain.
HOW DOES INFLATION AFFECT INVESTMENTS?
While you will see the effects of inflation first in your monthly budget, inflation can have a big effect on your investments over time. This happens in two ways.
The first is that the dollar amount of all your bank accounts and investments is simply worth less as inflation increases. While interest will help to offset this by increasing the overall value of your investments, each dollar you own is still worth less than before.
The second is through interest rates. The main tool governments have to control inflation is to increase the interest they pay on government debt, such as treasury bonds, and to increase the regulated interest rate at which banks are allowed to borrow from each other “overnight” to keep enough money on hand each day.
The rates the government offers become benchmarks for interest charged on loans and paid on investments throughout the economy, making it harder for companies to borrow the money they need to meet increasing demand, eventually breaking the spiral of inflation.
Unfortunately, inflation and higher interest rates also affect your balances and holdings. Let’s take a closer look at the impact this has on different types of investment.
Real Estate
Investing in a fixed, tangible asset can often protect your money from inflation, and few assets are more tangible than real estate. There are two reasons for this.
Firstly, unlike liquid assets like cash, fixed assets like real estate increase in value along with inflation, meaning the money you have invested in a home will also increase in value, rather than losing value over time as cash.
Secondly, the government usually tries to tackle inflation by raising interest rates, while the interest rate you pay on your mortgage is usually fixed, at least temporarily. If you pay less interest on your loan than the prevailing market rates, you are effectively borrowing money for less, while the underlying value of your home continues to increase in line with inflation.
Together, these factors make owning a fixed asset like a home a powerful hedge, or protection, against the loss of cash value inflation brings.
Stocks, Bonds and Mutual Funds
Investing in company stocks directly or indirectly through mutual funds can be a way to earn much more interest on your money but with more risk of actually losing your investment, and less certainty about how much money you will make in a given period.
The right investments, especially in large established mutual funds, large companies, or “safe” assets like gold—can outperform inflation. At the same time, companies you invest in also need to borrow money. So if higher interest rates start to slow the economy as a whole, the share prices of these companies may fall and they will pay less in dividends.
You can reduce your risk by buying into guaranteed government debt in the form of bonds. This can pay good returns when interest rates are high, but these are usually long-term investments. You’ll also pay significant fees to both invest and disinvest in stocks and bonds and you will be taxed on most earnings too.
Cash Savings
Cash savings in the form of savings accounts, money market accounts, or certificate account deposits are liquid assets–meaning your money is readily available to you as cash should you need it. That convenience comes at a price because your bank or credit union cannot lend on the cash as higher interest loans so you, in turn, earn relatively little interest on your balance.
That can be a particular problem for cash savings when inflation is high. While the actual dollars in your account are protected by federal deposit guarantees, there is nothing to stop the real-world value of those dollars from falling over time as inflation increases.
The only way to do this is to try to offset the loss in value to inflation by earning more interest on your balance, which is normally not possible without exposing assets to more risk. As a result, while your original investment is very safe in a deposit account, it may still be worth less over time because of inflation.
Smart Choices for Tough Times
Even if you have protected some of your assets from inflation by investing in property or stocks and bonds, it pays to be wise about the more liquid assets you need to keep closer to hand in your bank or credit union deposit accounts.
When it comes to offsetting the effects of inflation on your cash, every bit of interest counts. While dividends paid on savings and money market accounts offer some respite, share certificate accounts offer flexible terms and guaranteed returns with all the same protections.
When you invest in a share certificate, you’ll need to be prepared to commit your money for a period of your choosing, usually between three months and several years. But you will earn a fixed interest rate and regular dividend reinvestments, so you’ll know exactly how much you will earn up front.
Share certificates can pay significantly better interest rates than money market accounts and you have the full assurance that your money is safe, no matter what happens in the stock or property markets.
SAY YES TO INFLATION-BEATING SAVINGS OPTIONS
When times are tough, it’s important to get the most out of what you have. At GHS Federal Credit Union, we offer smart choices for protecting our members’ hard-earned cash from inflation—including our safe, flexible, and high-earning share certificates.
A GHS FCU share certificate offers:
Competitive rates
Flexible terms from 3-60 months
Minimum investments from $500
Fixed dividend and maturity dates
Full NCUA insurance up to $250,000
Contact us today to find out more about our share certificate offerings and limited-time investment opportunities. Or just click below to learn more about smart investment opportunities for tough times.