What Happens When Inflation Is High?
Inflation is more than just higher prices. It changes how people spend, how businesses operate and how investors plan for the future.
Key Takeaways
During higher inflation, households cut back on nonessential spending, and businesses may raise prices or slow hiring.
Higher interest rates can make borrowing more expensive across the economy.
A diversified portfolio and inflation hedges may help your investment returns stay ahead of inflation over time.
Inflation is something we talk about regularly with clients, especially lately, with how much the cost of living has gone up.
For clients who are already retired or getting close, these conversations usually turn into a check-in on their overall plan—and whether their portfolio is prepared for inflation's effects.
We’ll revisit their budget, go over spending and sometimes adjust their inflation assumptions to be a bit more conservative. We want to plan for what could happen, not just what we hope happens. That’s why it's important to understand how inflation can impact all facets of life.
Inflation Is a Normal Part of the Economy
Inflation is the rise in prices for goods and services over time, and a modest amount of inflation is normal in a growing economy. When inflation rises, each dollar buys less than it used to.
But when inflation stays elevated, it can strain budgets, weaken consumer confidence and slow economic activity. Understanding these ripple effects can help investors put inflation in context and make more informed decisions.
Inflation results from supply and demand forces. Different layers of inflation can influence consumer prices, monetary policy decisions and inflation trends affecting households and markets.
How Does Inflation Impact Households?
When I talk about inflation with clients, I try to keep it simple and relatable, focusing on how it affects their day-to-day life and their ability to maintain their lifestyle over time.
For most people, inflation becomes real at the checkout line, at the gas pump or when monthly bills increase. When these expenses start taking a larger share of the household budget, there’s less room for discretionary spending. People may postpone vacations, dine out less often, put off major purchases or look for cheaper alternatives instead of their usual products and services. They may even question whether they can keep investing.
The Consumer Confidence Index® is a widely followed indicator of overall consumer spending. It measures consumer attitudes and current and future expectations of business and employment conditions. Policymakers, economists and businesses use the data to guide decision-making.
With less budget flexibility, people may not feel comfortable spending money, even on things they can still afford. If enough consumers do this at the same time, business revenue can weaken and overall economic growth may slow.
Who Feels It Most?
Inflation doesn’t affect everyone equally. The effects can vary widely depending on income, spending patterns, savings and debt.
Households that spend a larger share of income on essentials may feel the impact more quickly. Retirees or others living on a fixed income may also feel more pressure if their income can’t keep pace with rising prices.
And if interest rates rise, borrowers taking on debt at higher rates will be affected more than those with lower, fixed-rate debt.
You can use this calculator to see how inflation can eat away at investment balances over time.
How Does Inflation Affect Businesses?
Businesses often feel inflation from multiple directions: wages, raw materials, transportation and borrowing. Some businesses raise prices to protect profit margins. Others try to absorb part of the increase, which can reduce business earnings. Some may delay their expansion plans, cut expenses or become more cautious about hiring.
Not every company is affected the same way. Businesses with strong demand or pricing power may be better able to pass higher costs on to customers. Others may struggle if consumers become more price sensitive.
What’s the Relationship Between Interest Rates and Inflation?
When inflation remains high, the Federal Reserve (Fed) may raise interest rates to help cool demand. Higher rates can make borrowing more expensive, which can slow spending and investment.
Consumers may notice this through higher rates for mortgages, vehicle loans, credit cards and other financing. Businesses may face higher costs to borrow for expansion, equipment or operations.
Learn how the Fed's interest rate decisions can influence financial market trends and affect your portfolio.
Which Investments Are Commonly Used as Potential Inflation Hedges?
Stocks, bonds and other asset classes respond differently depending on the inflation outlook, interest rates and expectations for economic growth. (See asset class definitions.)
Other Potential Inflation Hedges
Emerging markets. Stocks and bonds in emerging markets could be winners or losers, depending on the country. Commodity exporters in certain areas may benefit from rising inflation, but higher U.S. interest rates and a stronger dollar could hurt some emerging markets countries.
Real estate investment trusts (REITs). Exposure to properties that can demand higher prices or increase rents can be beneficial. REITs could go the other way, too. If higher interest rates accompany higher inflation, REITs could suffer, given their sensitivity to interest rate changes.
Diversification Is Key
Diversifying a portfolio with a variety of investments and inflation hedges may help reduce the impact of inflation. I frame it as a way to help smooth things out rather than avoiding volatility (and risk) completely. For clients relying on their portfolio for income, it’s important that their investments aren’t swinging too much, especially at the wrong time.
Diversification may help create a more balanced experience, so clients aren’t forced into tough decisions during market downturns.
Explore the role of various types of inflation hedges in your portfolio, whether you’re looking to preserve your purchasing power, you want to generate income or you're looking to grow your assets.
What Should Investors Do to Combat Inflation?
Inflation can be unsettling, but it doesn’t require a complete overhaul of your financial plan. In many cases, it’s best to review your strategy rather than react emotionally. You can also talk to a financial professional if inflation changes your priorities or planning assumptions.
Revisit your budget and spending assumptions.
Review whether your savings goals still reflect higher costs.
Understand how inflation may affect your retirement income needs.
Check whether your portfolio is still aligned with your time horizon and risk tolerance.
Fears about inflation are normal, but you can put these times in perspective by looking at the bigger picture. At the end of the day, we really want clients to focus on building a plan that can handle different environments and still keep them on track toward their goals.
Authors
Financial Consultant
Inflation in Focus
Get market updates, investment insights and portfolio ideas.
Federal Reserve (Fed) is the U.S. central bank, responsible for monetary policies affecting the U.S. financial system and the economy.
Treasury Inflation-Protected Securities (TIPS) are inflation-linked debt securities issued by the U.S. Treasury.
Commodities are basic raw materials such as precious metals and natural resources.
Value stocks tend to trade at a lower price relative to fundamentals and are thus considered undervalued by a value investor.
Growth stocks are the stocks of companies expected to have high growth potential.
U.S. Treasury securities are debt securities issued by the U.S. Treasury and backed by the direct "full faith and credit" pledge of the U.S. government.
Emerging markets bonds are issued by countries whose economies are considered to be developing or emerging from underdevelopment.
Real estate investment trusts (REITs) are securities that trade like stocks and invest in real estate through properties or mortgages.
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.
Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.
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.
Diversification does not assure a profit nor does it protect against loss of principal.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments portfolio. 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.