‘Inflation’ has become a catchword in use by every disgruntled grocery shopper to express their displeasure at the latest prices on the shelves. From spiking food costs, utility bills, or car prices, this invisible force erodes the purchasing power of a currency. But while the majority understand that inflation is an increase in the prices of goods and services, not many know the different ways it can occur, nor other similar economic situations that affect general price levels in the economy. Here’s a look at five inflation-related concepts and how they can affect your investments.

First, a basic understanding of inflation

Inflation is the result of gradual price increases for goods and services throughout the economy over time. It is a key economic factor influencing people’s purchasing power and impacting economic growth. 

Inflation is measured by calculating the year-over-year percentage change in the current prices of a set of goods and services. Analysts measure the rate of this movement by collecting data on price changes over a specific time interval.

Two main price indexes are used to measure inflation - the Consumer Price Index (CPI) and the Personal Consumption Expenditure (PCE) Price Index. 

The CPI, distributed by the Bureau of Labor Statistics, focuses on food, energy, and shelter, which make up 54% of the index. Shelter is the largest category, accounting for nearly a third of the index, followed by food at around 14% and energy goods and services at 7.5%.

The PCE Price Index, distributed by the Bureau of Economic Analysis, comprises of three main components: durable goods, nondurable goods, and services. Healthcare services are the largest category at 16.8%, followed by housing at 15.9% and financial services & insurance at 8.1%.

In tracking inflation, analysts also use a measure known as core inflation which calculates price changes while excluding the more volatile categories of food and energy prices. External factors such as environmental conditions and supply shocks often cause temporary price disturbances to these categories which may not reflect long-term inflation trends, and distort the economy’s price signals.

By focusing on core inflation, policymakers aim to maintain price stability, ensuring that inflation rates remain low and predictable.

In a healthy economy, modest levels of inflation are considered desirable; a 2% inflation rate, is widely considered ideal. This moderate inflation reflects a growing economy and healthy consumer demand However, high and volatile inflation rates can exert negative pressures on the market and lead to a breakdown of the economy.

Stagflation & Hyperinflation: extreme and sudden price surge

Stagflation and hyperinflation describe inflationary conditions at elevated growth levels enough to cripple the economy.

Stagflation, coined from the word stagnation and inflation, describes a type of inflation that is accompanied by high unemployment and stunted economic growth. This economic situation typically occurs after sudden external shocks that impact the supply of goods and services. A good example of Stagflation occurred in the 1970s, triggered by the twin oil shocks of the 1970s, brought on by the Arab oil embargo of 1973 and the Iranian Revolution of 1979. As oil prices tripled, businesses struggled with production costs, while workers demanded higher pay to sustain their purchasing power. This inflation crisis led to unacceptable levels of unemployment, recession, and economic instability with the US government even discouraging investment activity.

Even more severe is Hyperinflation which is characterised by rapidly accelerating inflation rates up to hundreds or thousands of percentage points within months. Hyperinflation is usually a consequence of oversupply of money, or quite simply excessive money printing which has not been supported by economic growth. An economy is said to be in hyperinflation when the rate of inflation increases by more than 50% a month. This unrestrained surge in prices of goods and services leads to a loss of confidence in the currency, with consumers often hurrying to spend it or exchange it for other stable assets. Though rare, hyperinflation can lead to a rapid collapse of an economy and social upheavals. A historic example of hyperinflation occurred in Zimbabwe between 2007 and 2008 when the monthly inflation rate reached approximately 79 billion percent and consumer prices doubled daily. The currency crisis led to the abandonment of the country’s currency in favour of the US dollar and South African Rand as the medium of exchange.

Deflation: the flipside of the coin

Deflation, the opposite of inflation, is characterised by a sustained decrease in the prices of goods and services causing the value of a currency to increase. In the short-term, deflation might be attractive for consumers but it can eventually lead to economic disruptions and financial hardship. If consumers expect prices of goods to drop, they may delay spending, dampening economic activity and leading to a loss of profits for producers. The biggest risk of a deflationary environment is that it makes the burden of debt more challenging to manage. This is because falling prices mean reduced profits for businesses and less income for workers, making it difficult for borrowers to settle past debt which has now increased in value.

During the Great Depression of the 1930s, the US economy witnessed severe deflation at a rate. Consumer prices plummeted by nearly 25%, as debtors, businesses, and financial institutions panicked, hurrying to liquidate assets and pay off debts before they became more expensive. But with more people desperate to sell, prices dropped even further leading to a vicious cycle that brought hardship, unemployment, and poor economic output.

In cases where modest deflation is brought by technological advancements and improved production efficiency, it could offer some advantages as it is accompanied by economic growth and increased trade activity. For instance, the recent boom in the adoption of artificial intelligence technologies has the potential to enhance work efficiency across industries and reduce labor costs, resulting in more accessible prices for certain goods and services.

Reflation: Stimulating good inflation

Unlike the previous concepts discussed, reflation does not describe an economic environment of price level changes, but rather a period of deliberate policy-making aimed at stimulating economic activity to curb the effects of deflation and help a weak economy rebound. Although a reflationary environment increases inflation, the key difference between these two concepts is that inflation occurs as a result of the economy reaching its maximum growth capacity. Reflation on the other hand occurs after a period of economic slowdown or recession when an economy is striving to achieve full growth and maximum employment. Reflation methods include tax cuts, infrastructure spending, and lower interest rates.

In the wake of the Great Recession of 2007-2009, the US Federal Reserve utilised monetary policies such as increased money supply by buying bonds and other mortgage-backed securities, while lowering interest rates. These policies helped to stabilize the economy and increase economic activity, however, it was not until December 2017 that the US economy achieved its maximum growth capacity.

Investing in Inflation, Deflation & Reflation

It is essential to take into consideration the current economic environment when making portfolio decisions and investment plans. Here are a few recommendations:

In inflation:

1. Growth stocks often perform well as their value grows along with an inflating economy.
2. Gold, commodities, and real estate tend to grow in value
3. Fixed-income investors can keep pace with rising prices with Treasury Inflation-Protected Securities.

In Deflation:

1. Government-issued and other high-quality bonds are likely to outperform stocks
2. Defensive stocks such as consumer staples are more resilient
3. Liquid cash is highly valuable in periods of falling prices

In Reflation:

1. Early stage Cyclical stocks such as basic materials, consumer discretionary, and financials are favored in a rebounding economy.
2. Treasury yields are expected to rise for longer-dated maturities than short-dated maturities.
3. Growth Stocks benefit from reflationary central bank policies, specifically lower interest rates.

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