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Created on 15.11.2018

How inflation affects your investment

Most people will have heard of inflation. After all, it is always in the news – whether in relation to hyperinflation in developing countries or inflation forecasts in Switzerland. Inflation is also of great interest to investors – on one hand, it can cause turmoil on the stock markets, while, on the other, rising prices can be offset through smart investment.

Inflation and rising prices – what does this mean exactly? Swiss investors don’t usually ask themselves this question. Yet, inflation has an impact on the extent to which it is worth making an investment, or, conversely, why saving rather than investment really isn’t the best option. Inflation occurs when the general level of prices rises. This means that products become more expensive or we can afford less with the same salary (rising prices). We notice this in the cost of food and electricity in particular. This can happen because raw materials or labour, for example, become more expensive. If the cost of purchasing oil rises, products made from it also become more expensive. This leads to a decline in purchasing power.

However, the main reason for inflation is usually a country’s monetary policy. If the central bank pursues a loose monetary policy and provides banks with more money accordingly (for example, in the form of loans), the amount of money available also increases. This usually causes consumer demand for various products to grow – and their prices to rise.

Inflation is calculated based on a shopping basket containing everyday items. This calculation can be made for all countries and is comparable. At 0.5% to 1% on average, Switzerland has a moderate rate of inflation. Very high inflation where the amount of money in circulation increases sharply and the rate of inflation climbs by 50% per month tends to be rare. It is an indicator of crisis in the countries concerned. Such examples of hyperinflation, where banknotes are printed in absurdly high quantities, occur most frequently in developing countries.

The key rate – an important means of regulating inflation

The key rate is closely related to inflation. In Switzerland this is set by the Swiss National Bank (SNB) to control inflation. The key rate is the rate at which banks can borrow money from the SNB. The banks in turn pass this onto businesses in the form of debt interest. When key rates are low, loans are less expensive for businesses and consumers. This makes investment more lucrative, generating economic growth. Consumers also spend more money due to low interest rates on loans. This causes the economy to grow and inflation to rise. However, this annoys savers because they receive a low return on their savings.

Savers are pleased when key rates are high as they obtain more interest on their savings accounts. In contrast, borrowers and consumers take out fewer loans or spend less money. The economy slows down because people generally spend less.

The next time you hear or read that the SNB or US Federal Reserve have lowered or increased key rates, you’ll know what’s going on: a higher or lower amount of money is flowing into the economy. Central banks obviously don’t just adjust key rates due to inflation.

Why inflation is also important to your investment

Every change to key rates or the rate of inflation has implications for the financial market. For example, the stock market benefits from moderate inflation  up to 4%. It signifies a growing economy with eager consumers. However, if inflation rises too sharply, this causes uncertainty. It can indicate that the monetary policy of major countries is too lax. This can in turn point to an economic crisis or structural problems.

In contrast to shares, changes to key rates have a major impact on bonds. If you have purchased a bond bearing low interest, it loses value as soon as new bonds offering higher interest come onto the market. This means choosing the right time to invest in bonds is vitally important. If inflation is moderate, many investors prefer to put their money into shares rather than bonds. 

Gold as a means of inflation protection

If the rates of inflation are high, many investors buy gold. This is mainly due to psychological factors: tangible assets – such as precious metals – give investors a greater sense of security than shares, bonds or funds in times of economic crisis or stock market corrections. Gold is usually only a suitable means of protection against inflation if the rate of inflation stands at over 5% – or if hyperinflation prevails. More on this can be found in the article entitled “How can I invest in commodities?”

Investors benefit more than savers especially when inflation is low

In times when low rates of interest are paid on savings accounts, investors benefit more than savers. Savers often only just manage to offset inflation on their savings with interest income. By contrast, investors can prosper in a low interest-rate environment by making smart decisions. This means selecting the right companies and sectors – those expecting higher rates of inflation should invest in companies which can then actually demand higher prices for their goods. Investors don’t need to worry about inflation-related risks at present: rates of inflation of between 1% and 3%, which are currently found in Switzerland, most EU countries and the USA, indicate a moderate to good economic climate.

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