Inflation Risk Analysis
Inflation risk analysis refers to the assessment risk that inflation will undermine the performance of
an investment, the value of an asset, or the purchasing power of a stream of income. Looking at
financial results without taking into account inflation is the nominal return. The value an investor
should worry about is the purchasing power, referred to as the real return. Inflation is a decline in the
purchasing power of money over time, and failure to anticipate a change in inflation presents a risk
that the realized return on an investment or the future value of an asset will be less than the expected
value. Any asset or income stream that is denominated in money is potentially vulnerable to
inflationary risk because it will lose value in direct proportion to the decline in the purchasing power
of money. Lending a fixed sum of money for later repayment is the classic example of an asset that is
subject to inflationary risk because the money that is repaid may be worth significantly less than the
money that was lent. Physical assets and equity are less sensitive to inflationary risk and may even
benefit from unanticipated inflation.
Effects of Inflation
1. Erodes Purchasing Power
This first effect of inflation is really just a different way of stating what it is. Inflation is a decrease in
the purchasing power of currency due to a rise in prices across the economy. Within living memory,
the average price of a cup of coffee was a dime. Today the price is closer to three dollars. Such a
price change could conceivably have resulted from a surge in the popularity of coffee, or price
pooling by a cartel of coffee producers, or years of devastating drought/flooding/conflict in a key
coffee-growing region. When the prices of goods that are non-discretionary and impossible to
substitute—food and fuel—rise, they can affect inflation all by themselves. For this reason,
economists often strip out food and fuel to look at "core" inflation, a less volatile measure of price
changes.
2. Encourages Spending, Investing
A predictable response to declining purchasing power is to buy now, rather than later. Cash will only
lose value, so it is better to get your shopping out of the way and stock up on things that probably
won't lose value. For consumers, that means filling up gas tanks, stuffing the freezer, buying shoes in
the next size up for the kids, and so on. For businesses, it means making capital investments that,
under different circumstances, might be put off until later. Many investors buy gold and other
precious metals when inflation takes hold, but these assets' volatility can cancel out the benefits of
their insulation from price rises, especially in the short term.
3. Causes More Inflation
Unfortunately, the urge to spend and invest in the face of inflation tends to boost inflation in turn,
creating a potentially catastrophic feedback loop. As people and businesses spend more quickly in an
effort to reduce the time they hold their depreciating currency, the economy finds itself awash in cash
no one particularly wants. In other words, the supply of money outstrips the demand, and the price of
money—the purchasing power of currency—falls at an ever-faster rate. When things get really bad, a
sensible tendency to keep business and household supplies stocked rather than sitting on cash
devolves into hoarding, leading to empty grocery store shelves. People become desperate to offload
currency so that every payday turns into a frenzy of spending on just about anything so long as it's
not ever-more-worthless money.
4. Raises the Cost of Borrowing
If interest rates are low, companies and individuals can borrow cheaply to start a business, earn a
degree, hire new workers, or buy a shiny new boat. In other words, low rates encourage spending and
investing, which generally stokes inflation in turn. By raising interest rates, central banks can put a
damper on these rampaging animal spirits. Suddenly the monthly payments on that boat, or that
corporate bond issue, seem a bit high. Better to put some money in the bank, where it can earn
interest. When there is not so much cash sloshing around, money becomes more scarce. That scarcity
increases its value, although as a rule, central banks don't want money literally to become more
valuable: they fear outright deflation nearly as much as they do hyperinflation. Rather, they tug on
interest rates in either direction in order to maintain inflation close to a target rate (generally 2% in
developed economies and 3% to 4% in emerging ones). Another way of looking at central banks' role
in controlling inflation is through the money supply. If the amount of money is growing faster than
the economy, the money will be worthless and inflation will ensue.
5. Lowers the Cost of Borrowing
When there is no central bank, or when central bankers are beholden to elected politicians, inflation
will generally lower borrowing costs. When levels of household debt are high, politicians find it
electorally profitable to print money, stoking inflation and whisking away voters' obligations. If the
government itself is heavily indebted, politicians have an even more obvious incentive to print
money and use it to pay down debt.
6. Reduces Unemployment
There is some evidence that inflation can push down unemployment. Wages tend to be sticky,
meaning that they change slowly in response to economic shifts. Unemployment surged because
workers resisted pay cuts and were fired instead (the ultimate pay cut). The same phenomenon may
also work in reverse: wages' upward stickiness means that once inflation hits a certain rate,
employers' real payroll costs fall, and they're able to hire more workers..
7. Increases Growth
Unless there is an attentive central bank on hand to push up interest rates, inflation discourages
saving, since the purchasing power of deposits erodes over time. That prospect gives consumers and
businesses an incentive to spend or invest. At least in the short term, the boost to spending and
investment leads to economic growth. By the same token, inflation's negative correlation with
unemployment implies a tendency to put more people to work, spurring growth.
8. Reduces Employment, Growth
Wistful talk about inflation's benefits is likely to sound strange to those who remember the economic
woes of the 1970s. When growth is slow, unemployment is high, and inflation is in the double digits,
you have what a British Tory MP in 1965 dubbed "stagflation." Economists have struggled to explain
stagflation. Early on, Keynesians did not accept that it could happen, since it appeared to defy the
inverse correlation between unemployment and inflation described by the Phillips curve. After
reconciling themselves to the reality of the situation, they attributed the most acute phase to the
supply shock caused by the 1973 oil embargo: as transportation costs spiked, the theory went,
the economy ground to a halt. In other words, it was a case of cost-push inflation.
9. Weakens or Strengthens Currency
High inflation is usually associated with a slumping exchange rate, though this is generally a case of
the weaker currency leading to inflation, not the other way around. Economies that import significant
amounts of goods and services—which, for now, is just about every economy—must pay more for
these imports in local-currency terms when their currencies fall against those of their trading
partners. Say that Country X's currency falls 10% against Country Y's. The latter doesn't have to raise
the price of the products it exports to Country X for them to cost Country X 10% more; the weaker
exchange rate alone has that effect. Multiply cost increases across enough trading partners selling
enough products, and the result is economy-wide inflation in Country X. But once again, inflation
can do one thing, or the polar opposite, depending on the context.
