What is Inflation?

You may remember from Economics 101 that inflation is basically defined as “too much money chasing too few goods and services.” Here’s what that means for investors.

At its most basic, inflation means it costs more money to buy goods and services. It means that dollar bill in your pocket isn’t worth as much right now as it was ten years ago. 

For investors, inflation is widely believed to be detrimental to bonds, but there are conflicting opinions on how it influences stocks. In a nutshell, the positive impact of inflation on the top line is nullified by various associated costs, resulting in a neutral bottom line. So the equity side of the balance sheet faces almost no impact from inflation, resulting in a neutral return on equity but a higher debt-to-equity ratio.

It’s worth pointing out, however, that inflation is intimately tied to interest rates. Inflation is the number-one driver of higher interest rates, and that’s controlled to some extent by the Federal Reserve. 

Throughout its history, the Fed’s priorities have evolved to reflect changes in the economy. Prior to World War II, its role generally remained limited to maintaining financial market stability and preserving the value of the dollar. With the arrival of the war, the Fed’s policy shifted to help keep interest rates low to facilitate the government’s war borrowings. In the decades after the war, the Fed’s primary objective was to keep inflation tamped down – occasionally raising interest rates to “remove the punch bowl just as the party was getting started.” 

In short, forecasting the dollar’s trend is a notoriously difficult task due to the myriad of variables involved. For investors, the overall economy is worth keeping an eye on, however, the answer to the “what to do with your money” question is obviously to invest it.

Investing puts your money to work for you and offers the possibility of outpacing inflation and even multiplying it over time.

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