What is inflation?

This article provides an overview of why inflation is one of the most important variables in economics, how inflation is created and measured, and how to hedge against rising inflation.

The most important facts in brief Inflation refers to the rise in prices of goods and services within a certain period of time. Inflation usually results from a short-term increase in production costs or the demand for certain goods, or from a long-term increase in money supply. Inflation is relevant to saving and investing because it reduces the real value of money invested and therefore negatively impacts returns.

1. Basics

Inflation generally refers to the rise in prices of goods and services over a given period of time. For the year 2021, the inflation rate in Germany was 3.1 percent. This means that an average purchase in the supermarket that cost 100 euros at the end of 2020 cost 103.10 euros one year later. The purchased goods have become more expensive by 3.10 euros or 3.1 percent. Inflation is therefore also referred to as the inflation rate. Economists refer to this as an increase in the price level in an economy. From the point of view of consumers, it means a loss of purchasing power.

There are different ways of measuring inflation. Apart from food prices, the calculation usually includes: costs for petrol, heating oil, craftsmen's services or overnight stays in hotels. The costs of these goods and services are recorded in a so-called Consumer Price Index (CPI). The inflation rate is the percentage change in this consumer price index over a certain period of time.

Inflation arises for a variety of reasons. There is economic consensus that inflation in the short and medium term is usually caused by an increase in production costs or in the demand for certain goods. Likewise, economists agree that excessive growth in money supply drives inflation in the long run and that very high rates of inflation are harmful. Therefore, many economists favour rather low, albeit consistently positive, inflation rates. This is reflected in the objectives of central banks, which generally have the mandate to maintain price stability, which is synonymous with controlling inflation. The European Central Bank (ECB), for example, has set itself the goal of maintaining inflation at two per cent, with an equal aversion to deviations below and above the target. It tries to achieve this through its monetary policy. The ECB's tools include adjusting the key interest rate and bond-buying programmes.

Other terms often mentioned in economics in connection with inflation are:

Deflation: a decline in the general price level (opposite of inflation)
Disinflation: declining growth in the price level
Hyperinflation: an inflationary spiral out of control (very strong inflation)
Stagflation: a combination of inflation, slow economic growth and high unemployment (an undesirable scenario for an economy)

2. Measuring inflation

The cost of living depends on the prices of many goods and services. To measure the cost of living for the average consumer, government organisations (such as the Federal Statistical Office) conduct surveys of households to determine a basket of frequently purchased items and frequently used services, and track the cost of this basket over time. The costs at a given point in time, expressed relative to a base year, represent the consumer price index (CPI). The percentage change in the CPI over a period of time denotes consumer price inflation, which is the most commonly used measure of inflation. For example, if the base year CPI is 100 and the current CPI is 110, inflation over that period is ten per cent. Typically, the CPI is calculated on a monthly basis. Moreover, the usual observation period is one year, which means that inflation can often be interpreted as the percentage inflation compared to the same month of the previous year.

Core inflation is also often mentioned when discussing inflation topics. This is a measure of inflation that excludes certain products such as food and energy, whose prices are more prone to fluctuation and are influenced by seasonal factors. The price of oil in particular, as a single factor, has had a strong influence on inflation rates. Therefore, in addition to inflation, the adjusted measure of core inflation should also be considered when assessing an economy. This is why central banks pay particular attention to core inflation in their efforts to achieve price stability.

The consumer price index basket is usually kept constant over a longer period of time and only occasionally adjusted to reflect changes in consumer behaviour or new trends. For example, coffee pods and capsules or fees for streaming services were added to the basket some time ago in order to represent current consumer behaviour in a contemporary way. The following list shows the components and weighting of the consumer price index basket for the Euro area (as of 2022).

1. Food and non-alcoholic beverages	16.6%
2. Alcoholic beverages and tobacco products	4.3%
3. Clothing and footwear	5.3%
4. Housing, water, electricity, gas and other fuels	17.9%
5. Furniture, lighting, appliances and other household accessories	6.7%
6. Health	5.1%
7. Transport	14.6%
8. Post and telecommunications	3.1%
9. Recreation, entertainment and culture	7.9%
10. Education	1.0%
11. Catering and accommodation services	8.0%
12. Other goods and services	9.7%

Source: https://www.ecb.europa.eu/stats/ecb_statistics/escb/html/table.en.html?id=JDF_ICP_COICOP_INW

3. Origin of inflation

In economics there are many theories and models about the origin of inflation. In general, a distinction must be made between the long-term and short-term view of inflation. The economic consensus is that long-term inflation is caused by excessive growth of money supply. In the short and medium term, however, inflation is primarily caused by the interaction of supply and demand.

Supply-side inflation, also called cost inflation, occurs when production costs rise due to increases in wages, energy or raw material costs, while demand remains stable. In order not to go bankrupt, producing companies have to pass on the increase in production costs to the end consumers, which results in price increases or inflation.

Inflation through demand pull occurs when the demand for goods increases so rapidly that suppliers cannot respond by increasing their supply quantities. According to market laws, this leads to price increases and thus to inflation. This type of inflation usually occurs in times of healthy economic growth.

4. What inflation means for investing

When investing, it is important to understand the relationship between nominal and real returns. The real return is calculated from the nominal return minus the inflation rate. For example, if I buy a share for 100 euros at the beginning of the year and sell it for 102 euros at the end of the year, I have made a profit of two euros - the nominal return is two per cent. However, if inflation had been three percent this year, the real return would have been negative (minus one percent) and thus I would have lost purchasing power. The investment slowed down the loss of purchasing power, but it could not compensate for it. Thus, I would have suffered a real loss of wealth. This example shows that the real return should always be considered for investments, i.e. the inflation-adjusted return. The reason for this is that ultimately the purchasing power gained is the most relevant criteria for an investor.

The situation is exactly the opposite if I am a debtor and am paying off a loan for a house, for example. The nominal value of the loan, i.e. the amount of money borrowed, is constant, while the price level rises. As a result, the loan amount loses value proportionally over time, while income from renting, for example, can potentially be adjusted to inflation

5. Hedging against inflation

In principle, there are several ways to hedge against inflation. Generally, tangible assets such as real estate or precious metals (especially gold) are considered inflation-proof. Commodities, inflation-linked bonds, but also shares are further investment options. It is important to note that not every asset class protects equally well in every inflationary phase. For example, equities can generate lower short-term returns in inflationary phases if companies cannot fully pass on their rising purchase prices to consumers. However, history shows that a broadly diversified equity portfolio can offer an expected return over the long term that is positive even after deducting the inflation rate.

Unlike commodities and real estate, inflation-linked bonds are a less volatile asset class to hedge against inflation risk. With this type of bond, the nominal value and coupon payments are linked to a consumer price index and adjusted for inflation. If the inflation rate rises, the price of an inflation-hedged bond also rises. The coupon of an inflation-linked bond is also called the real coupon, and the yield is called the real yield. Income from such a bond, therefore, does not reduce in purchasing power due to inflation.

ETFs offer a simple way to invest in shares, commodities and (inflation-protected) bonds in a bundled and globally diversified manner.

Stefan Wennemar, CFA

Stefan is a Senior Portfolio Manager in the Wealth Management team. He specialises in portfolio management, data analysis and research on capital market topics. He holds a Bachelor's degree in Economics and Business Administration from Goethe University in Frankfurt and a Master's degree in Finance from the Stockholm School of Economics.

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