If you've ever felt the pinch of escalating prices at the gas pump or the grocery store, you've experienced first-hand the effects of inflation. Inflation is defined as a sustained increase in the prices of goods and services, which translates into a decline in the purchasing power of your money. The following chart illustrates the decline in the value of a dollar since 1979.

The Shrinking Dollar

This graph shows the shrinking dollar over time.

Source: American Century Investments, Inc., based on data provided by the Bureau of Labor Statistics.

Inflation can be bad news for borrowers and consumers and also for many types of investments. By understanding inflation and how it may affect you and your investments, you may be able to take measures to safeguard your portfolio in an inflationary environment.

Measuring Inflation

The U.S. Bureau of Labor Statistics measures inflation by pricing a number of goods that represent the economy and comparing the cost of those goods over time.

There are two main price indexes that measure inflation.

  • Consumer Price Index (CPI)
    CPI is the most commonly used statistic to measure inflation in the U.S. economy. It measures price changes in consumer goods and services such as gas, food, clothing and cars. It reflects price change from the consumer's perspective.
  • Producer Price Indexes (PPIs)
    PPIs are a group of indexes that measures price change over time by comparing the selling prices of domestic producers of goods and services. It measures price changes from the seller's point of view.

Over time, the CPI and PPIs indexes typically reflect a similar rate of inflation, but in the short term, PPI indexes are likely to show an increase before CPI.

Inflation and Interest Rates

You rarely hear about inflation without hearing about interest rates. And for good reason. Interest rates are decided by the Federal Reserve's Open Market Committee based in part on what the CPI and PPIs indicate about the state of the economy. Interest rates are tied to the credit market, because higher interest rates make borrowing more expensive. By adjusting interest rates upward or downward, the Fed attempts to maintain a healthy level of economic growth in the U.S. economy. To boost employment and stimulate healthy economic growth and stable prices of goods and services, the Fed may lower rates. As interest rates drop, consumers typically spend more, which in turn drives economic growth. Conversely, the Fed may hike rates to slow down an economy that's growing too fast.

Inflation and Investments

Inflation can be a serious problem for many types of investments. How it affects your portfolio depends on the types of securities you own and the amount of time you have to invest.

Fixed-income (bond) investors are most affected by inflation. That's because when inflation rises, interest rates generally rise as well, which in turn drives down bond prices. Bonds with longer maturities are hit the hardest. In addition, as the prices of goods and services rise, the purchasing power of interest paid on the bonds also declines. Over the long term, government bonds have lagged stocks in providing inflation protection.

Inflation also can be bad for stocks. An increase in inflation can send stock prices downward, because higher inflation increases the prices corporations must pay in the same manner that it does for consumers. It also can cut into the dividends corporations pay to their shareholders. However, over the long term, a company's earnings and revenues should increase in line with inflation.

Money market funds can provide a relatively safe place to park money and earn interest. That can make them a good option for investors looking to pocket some of their stock gains. Money market funds also can be a good place to be when the economy shifts into overdrive. When a strengthening economy overheats, leading to a rise in inflation, the Federal Reserve typically cools things off by raising interest rates. However, money market and other cash investments generally provide modest returns that may lag inflation over time.

An investment in a money market fund is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

Hedging Inflation

Inflation can outpace annual salary increases and even the rate of return offered by many investments, so it's important to make sure your money is working hard for you. To safeguard your portfolio and protect purchasing power during inflationary periods, consider these strategies:

Maintain Diversification
A balanced portfolio of stocks, bonds and money market securities can help reduce risk and mitigate the negative effects of rising inflation, because one investment type may be in favor when another isn't doing as well. Remember that diversification does not protect against loss in a declining market.

Consider Inflation-Fighting Investments
Real estate investments tend to perform well during inflationary periods, as do precious metals.

Bond investments, such as Treasury Inflation Protected Securities (TIPS), municipal and corporate inflation-linked securities, and inflation-linked Certificates of Deposit, are designed to provide investors with a return above the rate of inflation. However, while inflation-linked securities can be of great benefit in your portfolio when inflation is on the rise, their returns likely will fall below those of comparable fixed-rate investments when inflation eases. Because of this, many experts say that inflation-linked securities should represent only 5% to 10% of a portfolio.

Add Yield
Regular interest payments can act like shock absorbers to smooth out your portfolio's performance over time. Shorter-term government investments, such as government agency and short-term mortgages, typically offer more yield than comparable Treasury investments. Mortgage-backed securities, such as those issued by the Government National Mortgage Association (GNMA), are another option for adding yield with the same government guarantee as Treasury bonds.

Manage Debt
When inflation and interest rates increase, so will the interest you pay on your debt, which includes credit cards and adjustable-rate mortgage or car loans, so it makes sense to keep debt to a minimum. It's always smart to make your largest payments toward your highest-rate loans to pay them off as quickly as possible, but especially so when interest rates are rising.