What to know about inflation

What to know about inflation

Against a backdrop of squeezed supply chains, increased levels of demand as pandemic-related restrictions are eased and geopolitics, inflation has risen to levels not seen in some countries for over twenty years. With it likely to remain at high levels, it is important to remember the key elements about inflation and ways to mitigate against it.

What is Inflation?

Inflation is the term used to describe a rise in the general level prices.  As prices rise, people’s ability to purchase goods and services (known as purchasing power) falls.  How quickly prices rise is called the rate of inflation – it is quoted as a percentage and is measured on a monthly basis using price indices.  

When the rate of inflation is decreasing but is still positive we call it disinflation.  When the rate is negative (which means that prices are falling) we talk about deflation

Price indices use a “basket” of goods and services that people regularly spend money on such as food, transport and clothing.  The month’s prices are then compared with what it was a year ago to work out the current inflation rate.  According to its components there are two categories:

1. core inflation which is more representative of the structural evolution of prices (excludes volatile elements such as  food and energy)
2. headline which is the total inflation.  Inflation-linked bonds are linked to headline inflation which includes energy and food prices.

While calculation methods may vary across countries, the majority of mature countries, including the US and UK, use CPI (Consumer Price Index). In the European Union, all countries follow the same methodology called ‘Harmonised Index of Consumer Prices (HICP).

All these measures relate to realised, or past inflation.  However, when trading inflation-linked bonds, investors have their own forecast of what inflation will be in the future: market-based inflation expectations which is what we call “inflation breakeven”. Part four of this series, Market conditions and when to use inflation-linked bonds, will study this in more detail.

There are several factors that can cause inflation, money supply growth outstripping level of productivity, excess demand, rising costs, weak currency causing imports to be expensive, and even just the anticipation of inflation can cause inflation.

Whatever the cause, it no longer is a localised event. The old saying ‘If the US sneezes, the rest of the world catches a cold’ holds true for inflation as inflation is very correlated across countries. This is because of the globalization of the economy, global pricing of raw materials and the integration of economic cycles.

This means that when it comes to mitigating the effects of inflation, there is a diversification benefit in taking a global approach. On top of this, as can be seen in the chart below, global inflation-linked bonds can provide a better risk-adjusted return than many local inflation strategies.

As this module has shown, there are many different causes for inflation and a variety of measurements that can be used to calculate inflation.  It is worth investors reviewing the effects of inflation on their portfolio from a global perspective, not just their local market. With this in mind, the second in our series, Adding to the toolkit: inflation-linked bonds will look in more detail at inflation-linked bonds and how they can be used as an investment solution for offsetting the impacts of inflation.