What is Inflation and How Does it Affect Investors?

If you bought a basket of items — things like food, furniture and clothing — for $100 in 1985, that very same basket of goods today (2019) would cost you $217.86.* That increase, in this case a nearly 118 per cent jump, is what's known as inflation.

Quite simply, inflation is the general increase in the price of goods and services over time, which reduces your purchasing power. Not to be confused with shifting prices of individual items, inflation is an economy-wide decrease in purchasing power; a dollar today doesn't go as far as it did in years gone by.

When the cost of living rises — in other words, the amount it takes to maintain a certain standard of living — it can put a dent in the average person's bank account. But what about investments?

Here are some key points investors should know about inflation.

How Do You Measure Inflation? 

The rate of inflation is commonly measured by the Consumer Price Index (CPI). According to Statistics Canada, which compiles and reports Canadian data monthly, CPI "is an indicator of changes in consumer prices experienced by Canadians. It is obtained by comparing, over time, the cost of a fixed basket of goods and services purchased by consumers. Since the basket contains goods and services of unchanging or equivalent quantity and quality, the index reflects only pure price change."

So, milk in litres, toothpaste by the tube or Internet access by the month — it's all gathered and recorded to determine how much we're paying for things. Inflation means people are paying more money for the same amount. This can lead to slower economic growth if people reduce their purchases of necessities and non-essentials.

What Affects Inflation?

While there are many factors that contribute to inflation, two categories stand out: cost-push and demand-pull.

Cost-push inflation. This happens as a result of supply-side factors. While there's no increase in overall demand, prices rise because of things like higher production costs and higher costs for raw materials and labour.

Demand-pull inflation. This is when increased demand in an economy, caused by a wide variety of factors, ultimately sends aggregate pricing higher.

Investing Through Rising Inflation

As mentioned, inflation can be hard on a bank account. It eats up purchasing power, pushing the cost of living higher. For investors, it can be viewed positively or negatively, depending on the type of investment, investing timelines and overall goals.

For example, fixed-income investors may worry about higher inflation eating into their ultimate returns over the long term. Let's say a bond pays 2 per cent and inflation reaches 4 per cent, your return would be negative 2 per cent once adjusted for inflation.

For investors holding real assets, such as a home, inflation can increase the value of that home, but it can also raise the initial purchase price for anyone looking to enter the housing market. When it comes to mortgages, while the amount borrowed would stay the same, the price of a house would increase with inflation.

Many investors believe that equities provide potential protection against inflation. Publicly traded companies can raise the price of their goods or services to cover the higher costs caused by inflation, and that ability to raise prices means companies can expand to at least keep pace with the rate of inflation. That, in turns, can allow companies to maintain or continue to increase profit margins, benefiting shareholders.

In the volatile sociopolitical environment of recent years, some investors have expressed concerns about low inflation — based on fear of slowing economic growth and potential recession. However, higher inflation can also be a concern for both investors and the economy. This is why we rely on central banks to help smooth out inflation with monetary policy.

What Role Do Central Banks Play?

The relationship between interest rates and inflation is tight, which helps explain why investors keep such a close eye on interest-rate decisions from the Bank of Canada, the Federal Reserve (the Fed) in the U.S. and other central banks around the world.

Part of the job of central banks and other monetary authorities around the world is to keep inflation at a level they deem to be reasonable. Canada's inflation target, for example, is set by the Bank of Canada and the Minister of Finance for a specific period of time. The current target, renewed in 2016 and lasting until 2021, is 2 per cent (the mid-point in a 1 to 3 per cent range).

As part of maintaining steady inflation, central banks are responsible for setting short-term interest-rate targets. Generally speaking, when interest rates rise, people are more likely to save; when interest rates are lower, they're more likely to borrow and spend. We've witnessed this recently in Canada with historically low interest rates and white-hot real estate markets. 

*According to the Bank of Canada's online inflation calculator.