What is inflation and how does it affect investments?

Inflation plays an important role in shaping our economy and influencing the prices of goods and services. It’s when we see an increase in prices and a decrease in the actual value of our money.

The Office of National Statistics (ONS) estimates inflation monthly by checking the prices of things that people regularly buy. These span from things like a loaf of bread, to a holiday.

To estimate inflation, the ONS takes the price of these items and compare it to the year before. The change in price level will then give us the rate of inflation.

Inflation is categorised into three types:

Demand-pull inflation

Demand-pull inflation happens when the demand for goods and services outweighs the supply. This then results in higher prices. There are four reasons demand-pull inflation happens:

• Government spending
• Growth in the economy
• An increase in export demand
• Higher money supply

Let’s think about it this way; imagine a small town that has one bakery, and that bakery bakes 100 loaves of bread a day and there’s enough for everyone.

One day, 150 people move into the small town but the bakery still only bakes 100 loaves of bread. Now, because people are competing for the same amount of bread, the bakery can charge higher prices. The bakery’s prices don’t rise because the cost to bake has increased, but because more people want it.

Cost-push inflation

Cost-push inflation happens when the price level in the economy rises due to the cost of production. It’s usually caused by:

• Rising wages
• Higher material costs
• Increased energy costs
• Government policies
• Supply chain disruptions

Let’s use the same bakery to break down cost-push inflation. This time, the price of flour has gone up because of a poor harvest. Now, because of this, the bakery’s cost to make each loaf has increased.

To cover these costs the bakery has increased the price of bread, even though the demand level hasn’t changed.

Built-in inflation

Built-in inflation can also be known as wage-price inflation, or inflationary expectations. It happens when workers and businesses expect prices to keep rising making them adjust things like wages, or goods prices. It can be caused by:

• Inflation expectation
• Indexation – adjusting prices or wages to reflect the effect of inflation
• Past inflation trends
• Wage changes

Again, we’ll use the bakery as an example. Imagine the bakery workers ask for a pay rise because the cost of living has gone up. To afford the workers’ higher wages, the bakery has to increase the price of bread.

As prices rise, workers throughout the small town need higher wages, creating a cycle where wages and prices keep rising together. 

The main way inflation affects our investments is the reduction of purchasing power – this means the money we have doesn’t stretch as far as it used to. For example, if your investment has grown by 5%, but the inflation rate is at 1%, your real return is actually only 4%.

But inflation reacts differently to different types of investment.

Inflation has slightly different effects based on the type of asset they are:

Stocks

Inflation affects stocks by the changes in purchasing power. When inflation rises, businesses often face higher costs. If these costs cannot be passed on to consumers, then the company's profit margins shrink. So, inflation should be something you consider if you're thinking about getting a product like a stocks and shares ISA or investing in individual stocks.

Bonds

Bonds are another product that can get hit hard by lower purchasing power as it affects the bonds future cash flows. Since bonds generally come with fixed interest rates you might not be making as much money as you think.

Real estate

House prices can jump to and fro when it comes to inflation. When inflation rises mortgage rates can rise with it, and if it rises too much, people may be unable to apply for loans meaning housing demand can decrease.

But when you flip it on its head high inflation can also cause housing prices to increase because of supply and demand. 

Inflation can also hit your savings as well. To make sure you’re 'beating' inflation check that the interest you’re making through your savings account is higher than the rate of inflation. To get the 'real rate' of interest you’re earning, take away the inflation rate from the 'nominal interest rate', which is the amount of interest your savings provider is offering you.

If you’re wondering how to manage risk when it comes to inflation, and you’re not sure where to start, we’d recommend you get in touch with a financial adviser.

You can also use our inflation calculator to get a broad estimate of how inflation could affect the future value of your savings or investments over time. Results are illustrative and can help you understand the potential impact of inflation on your money.

If you don’t have a financial adviser, why not see if we can help? Find out more about what advice we can offer