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Demystifying Inflation: Terms Investors Should Know

Stacks of United States currency.

After years of speculation about when prices would rise in response to continued economic growth, inflation finally emerged in the second half of 2021. Many are experiencing high and fast-rising inflation for the first time in their lives—or feel like it’s a new experience because it’s been so long. With rates continuing to rise, it’s important to understand the different types of inflation and how they can affect investment portfolios.

While the word itself has a negative connotation, inflation is a normal part of a healthy, growing economy. More money flowing through the economy typically leads to increases in prices.

The Federal Reserve sets a goal of 2% inflation over the long run, and individuals are accustomed to small cost increases for goods and services over time.

When prices climb significantly, however, inflation feels much less comfortable and becomes a buzzword that gets national headlines. But inflation isn’t always a straightforward concept. There are different types and levels of inflation, all of which can affect one’s investment decisions and leave a lasting impact on a financial portfolio.

Understanding the types of inflation the economy is experiencing can help guide you toward inflation hedges to balance your portfolio.

Basic Types of Inflation

Economists tend to identify three scenarios that lead to inflation.

Cost-push inflation refers to the increase in product costs that occurs when demand doesn’t rise accordingly. Examples can include increases in the cost of labor or production of a particular good or service that may force a company to raise the product’s overall cost, regardless of consumer demand for said product.

Demand-pull inflation means demand is high for a consumer good or service, pushing up prices to make the commodity appear more valuable to potential buyers. This demand leads to limited supply, driving prices even higher.

Built-in inflation, as mentioned earlier, is where the prices of goods and services tend to gradually rise over time. In turn, people expect higher wages to cover those higher costs. With more money in the economy from those higher wages, costs rise again.

What to Watch Out For

Since 2021, the U.S. economy has experienced a combination of all three types of inflation listed above. But there are other, more significant levels of inflation that often serve as a warning of economic collapse.

Hyperinflation occurs when inflation rates rise rapidly, beyond the control of central banks—think triple- and even quadruple-digit rates. With inflation at such levels, prices for basic goods are out of reach for many, frequently leading to social upheaval. Post–World War I Weimar Germany is one of the more prominent historical examples of hyperinflation, and Venezuela in the late 2010s serves as a more recent instance of skyrocketing inflation. While some worry that the U.S. is heading toward hyperinflation now, the last time the country came close was during the Civil War.

Stagflation describes a period in which an economy experiences poor (stagnant) growth and high unemployment rates alongside the rising prices typical of inflation. While raising interest rates would be a typical governmental response to inflation, doing so would be detrimental during a stagflation period, as consumers would be less able to afford rising costs, leading to more unemployment and higher rates of poverty. The U.S. in the 1970s experienced periods of stagflation as costs rose while the economy struggled.

Deflation is a decrease in prices for goods and services. It might seem that a drop in prices would be a positive turn, but if demand drops due to lower spending, businesses make less money and need to cut costs. The result could be increased layoffs, terminations and closures, leading to a negative overall economic effect.

What Investors Can Do

Looking for inflation hedges to ease rising costs before periods of higher inflation may be a good move to help shield portfolio values. If you’re in a period of inflation like our current one, you could consider higher-risk investments (if you don’t need your money in the next decade) that offer the potential for higher gains while providing some time to recover from downturns. Real estate investment trusts (REITs) and commodities (precious metals, oil and natural resource-related products) may be other options.

Another vehicle is TIPS. Like bonds, Treasury inflation-protected securities (TIPS) feature much less volatility than stocks or other asset classes and offer the benefit of outpacing inflation.

Inflation typically follows periods of economic growth. Unless an economy experiences the extremes of hyperinflation or stagflation, individuals can typically survive a period of rising costs without much damage to their financial portfolios.

Knowing the Concepts Helps Improve Decision-Making

A sound financial plan takes into consideration many different scenarios. Getting familiar with the terms and concepts around inflation equips you to make more informed decisions about your investment strategy and portfolio holdings. And because every investor's experience is different, you may want to consult a financial advisor to talk through what you've learned and ways to apply it your own situation.

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Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Investments in fixed income securities are subject to the risks associated with debt securities including credit, price and interest rate risk.

In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Interest payments on inflation-protected debt securities will fluctuate as the principal and/or interest is adjusted for inflation and can be unpredictable.

Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.