Is Inflation Good or Bad for an Economy?
Answering the question Is Inflation Good or Bad for an Economy is a complex one. Inflation isn’t always a terrible thing; central banks want to see inflation around 2%, which is a steady rise and reflects a strong economy.
A strong economy means that businesses are producing, consumers are purchasing, wages, employment, and business are all increasing, and this is all good news.
Is Inflation Good or Bad?
What is Too Much Inflation?
Deciding is Inflation Good or Bad for an Economy it is important to identify how much inflation we actually need.
When inflation rises much above 2%, investors become concerned. A big increase in prices and goods will reduce customers’ purchasing power. For example, suppose you have £1000 in your bank account but inflation is 8%. In practise, £1000 no longer buys the same number of items. You are effectively losing money due to inflation. You’ve probably observed how prices rise over time, and for the most part, we can blame it on inflation.
Who Suffers During Periods of High Inflation?
As previously stated, savers are included in the losers column. Exporters may also struggle if their competitiveness declines. For example, if UK inflation is higher than in other nations, goods would become less competitive, and exporters will notice a drop in demand, making it difficult to sell their goods.
Borrowers with variable rates will struggle just as much as workers with fixed wages. From a market standpoint, the economy will struggle as it goes through a period of uncertainty. People have less confidence and are less inclined to invest when times are uncertain. This can result in slower economic growth and fewer job opportunities, for example.
Who Benefits During Periods of High Inflation?
When we talk about the winners, we might start talking about something called hedging. At instances when investors believe inflation will grow, where should they put their money? What types of assets often do well?
Gold has long been thought to be a good hedge, as have some commodities, real estate investment trusts, and, of course, some stocks tied to the aforementioned.
It’s worth noting that there will be moments in the market when inflation is strong but gold doesn’t do well. Similarly, despite historically performing well as an inflation hedge, the other assets indicated above will struggle at times.
As a result, we must keep in mind that, depending on the circumstances, assets will perform better or worse under inflation. If you are a long-term investor, it may not disturb you if your holdings struggle for a short period of time. Yet, if you want to be more active in the markets and thus more reactive to changes in the macro environment, you need have a playbook for each scenario. Find out why inflation is rising, consider which markets will struggle to push higher, and if you have any exposure to them, either sell for a profit or cease investing in them.
Which Are the Best Investments During High Inflation?
You may be wondering if you can invest in specific markets that will begin to do well? To put it simply, you may assume that inflation will grow and that central banks would raise interest rates to keep it under control, so you decide to invest in banks on the belief that by hiking interest rates, they will earn a higher return on lending.
Yet, if inflation becomes uncontrollable, banks will not perform as well as they would in a modestly inflationary situation. If inflation is out of control and consumers can no longer buy what they could previously, demand will undoubtedly fall and there will be a lot of uncertainty, thus it may make more sense to invest in defensive equities such as consumer discretionary companies.
Commodities
Commodities, as previously mentioned, could be a decent inflation hedge. Commodities are regarded of as a buffer against inflation because of their intrinsic value, and they tend to perform well when consumer goods prices rise. Equities, on the other hand, tend to perform poorly when high inflation leads to interest rate increases, which tends to lower the value of future cash flows for firms due to the consequences of inflation.
According to Vanguard research, commodities surged by 7% to 9% for every 1% of unexpected inflation experienced by the economy over the last decade. Commodities’ low connection to stocks and bonds may appeal to investors looking for diversification. When inflation is on the rise, investors may regard commodities as a way to diversify their assets, which strengthens this argument.
In essence, inflation erodes consumer purchasing power, which lowers profitability and drives interest rates and bond yields to rise, lowering valuations. This can therefore cause a significant economic slowdown or possibly a recession.
The question investors ask during this period is ‘how long will it last?’. People frequently refer to the 1970s as the “lost decade,” when central banks lost power and credibility. With more instruments at their disposal, central banks can strive to respond more quickly to keep inflation under control.
Remember your ‘why’ at all times. If you are a long-term investor, be patient, diversify, and be proactive if something important changes.
Summary: Is Inflation Good or Bad?
After reading all of this, inflation may be frightening, but keep in mind that the stock market is often greater than inflation. From a US viewpoint, as we have noted earlier, the stock market averages a 10% return and inflation on average is under 3% a year.
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