How does investing help fight inflation?

Five things investors should know about inflation

  • The glut of money from central banks in the wake of the corona crisis is fueling the discussion about possible inflation risks.
  • If inflation rises, the purchasing power of money and wealth shrink.
  • Investors should invest in such a way that their returns remain above the inflation rate over the long term.

The inflation rate in Germany during the hyperinflation in 1923 averaged 322%.

Source: Phillip D. Cagan, The Monetary Dynamics of Hyperinflation, Chicago 1956, p. 2

The billion dollar rescue packages that were launched around the globe as a result of the corona pandemic are causing national debt to rise dramatically - and are already leading to the question of how the high mountains of debt can ever be paid off again in the future. About growth? Budget surpluses? Or about inflation? For Martin Moryson, DWS Chief Economist Europe, it is by no means certain whether the corona crisis will drive inflation in the long term. Nonetheless, it can make sense for investors now to study the effects of rising inflation rates in detail. The most important questions and answers on the subject of inflation at a glance.

Corona crisis: who should pay for it

How high do you rate the risk of inflation in view of the billions in measures against the corona crisis?

1. What is inflation?

Inflation is the increase in the price of goods and services, usually within a year. Statisticians measure value using a basket of different goods. In Germany, the Federal Statistical Office (Destatis) announces it every month.[1]

Inflation usually goes hand in hand with a loss of the purchasing power of money: after a year, less can be bought for an amount that has remained visually the same.

A bad harvest makes food prices more expensive - there are fewer goods. However, in addition to changes in supply and demand, other factors can be responsible for rising inflation, for example the borrowing of debts by states and a subsequent expansion of the amount of money in circulation by the central bank, which devalues ​​the money in the form of paper or bank balances.

The opposite of inflation is deflation - a sustained decline in the price level for goods and services. The danger: Consumers as well as companies would have an incentive to put the money, which is becoming more and more valuable, aside and to postpone purchases and investments over and over again. An economic downward spiral would start.

2. Why are central banks like the ECB pursuing a target of two percent inflation per year?

The primary goal of the European Central Bank (ECB) is to maintain monetary stability in the euro area.[2] As such, the central bank has set itself a value of “below but close to two percent” inflation - and not zero percent, as it might seem logical at first glance.

Background: The ECB wants to avoid the risk of deflation - in other words the opposite of inflation - and to secure a "sufficient safety margin" for this.[3] set up. For with roughly the same costs, the fight against deflation through monetary policy means is set at an interest rate of zero - which the central bank itself has been under since 2014 with a negative deposit rate for commercial bank balances. This has contributed to the fact that government bonds from the euro area, including Germany, yield a return of less than zero percent.

3. What are the risks of inflation?

Inflation reduces the purchasing power of money: If, for example, an employee always receives the same wage, he can afford less and less in view of the rise in prices. Savers should also keep an eye on inflation developments: if inflation rises, savings and assets shrink. Capital that is invested with a lower rate of interest than the inflation rate is constantly losing purchasing power. Therefore, investors should make sure when investing that the interest rate or return is above the inflation rate.

4. What can protect against inflation?

Real assets can usually offer protection against inflation. This includes gold, which has been recognized as valuable by people for thousands of years and which is one of the reasons why it was struck into coins in earlier times. Real estate is also considered a tangible asset: having one's own roof over one's head is recognized as a value, so that prices for houses or condominiums usually go in the same direction as inflation - especially since landlords can usually adjust the payments required by their tenants over the long term in accordance with the inflation rate .

But shares also represent real assets: They are shares in a company that in turn owns other real assets - and the shareholder thus a small part of it. This can be, for example, administration buildings or machines. On the stock exchange, a rise in share prices with rising inflation rates is therefore not uncommon.

There are also inflation-indexed bonds in which the nominal value and / or the coupon are linked to price developments. So if inflation rises, the interest payment due on these securities increases, for example.

5. What cannot protect against inflation?

Cash, for example. Its purchasing power is directly affected. With the change in the piggy bank, you may be able to buy one less ice cream after a year. The same applies to bank balances on current accounts. However, it also affects the money that savers have parked in overnight money accounts, for example. Their interest rate is currently below the inflation rate, resulting in a gradual loss of wealth. And that can be considerable under certain circumstances: After ten years and deducting an annual inflation rate of two percent, as the ECB is aiming for, a sum of 8,000 euros only has a purchasing power of 6536.58 euros. Even if the face value has remained the same, that is almost 1500 euros less in real terms.