In 2000, what was a single U.S. dollar in 1900 was equivalent to US$24 in the United States, US$48 in the UK, and US$12 in Switzerland just one hundred years later, according to Elroy Dimson, Paul Marsh and Mike Staunton in their book "Triumph Of The Optimists: 101 Years Of Global Investment Returns" (2002). These differences are quite startling to an international long-term investor. In this article, we'll take you through a history of how inflation impacted the market, and tell you how to use it to help you make future investments.

Few things are more devastating to your returns than unexpected inflation because it diminishes purchasing power. Throughout history, periods of high inflation or hyperinflation have decimated the savings of investors. Therefore, you can't completely understand your returns unless you look at them in relation to inflation.

In this segment of the "Look Back" series, we consider inflation and the subsequent real rates of return of holding cash (defined as holding Treasury bills or T-bills) over the past century. (To look back at other markets during this period, see The Bond Market: A Look Back, The Stock Market: A Look Back and Equity Premiums: Looking Back And Looking Ahead.)

Fixed income and cash have been influenced by similar events throughout history, as have the markets in which they trade. Two world wars and a global depression had a major impact on both cash and fixed income returns for the first half of the century. While lower real returns are likely for cash going forward, when compared to the post-1980 period, their importance as the benchmark for the risk-free return is likely to remain intact.

A Century of Two Tales
While the money (or cash) market did perform much better in the second half of the last century, it was really the last 20 years which have made the biggest difference. Expectations for high inflation remained intact long after inflation subsided in the early 1980s. This translated into much higher than normal real returns for cash during that period.

Figure 1

During the last century, all countries in the study at some point experienced deflation and double-digit inflation. In the 1970s, it was exactly this type of double-digit inflation that set the stage for the high real returns realized after 1980.

Some countries, like Germany, even experienced hyperinflation, as they did in the early 1920s. This is an important lesson, because T-bills are often thought of as risk-free investments. German investors, though, found out during this period that on a real-return basis, even T-bills are not immune to total loss during a period of hyperinflation, as inflation can far outstrip the returns investors receive.

With that said, T-bills today still handle the function of a short-term risk-free benchmark, while inflation-protected securities (IPS) are best used as a medium or long-term benchmark. (For more information, see Inflation-Protected Securities - The Missing Link.)

The hyperinflation experienced by Germany in the 1920s was not common to other countries over the last century. Inflation in the U.S. saw two peaks just after the World Wars. In 1918, it peaked at 20.4%, while in 1946 18.2% was the crest. Both periods of inflation were the result of heavy government spending during the war years. This scenario reveals a valuable lesson - those who have the ability to print money also have the ability to create inflation.

Interest rates approached 20% in 1981, strangling the world economy into a deep recession. From those ashes emerged the Great Bull Market (1981 to 2000), as inflation expectations remained much higher than the actual rate. As a result, high real returns remained intact for an unprecedented period.

What Does the Future Hold?
So what should we expect going forward? First, the real rates of return experienced from 1981 to 2000 were the exception rather than the norm.

Figure 2

The Great Bull Market is now over, but a new era exists for cash investors. Central banks around the world have a much better understanding of monetary policy than ever before. For the most part, actual interest rate increases today are a foregone conclusion by the time they are announced. This is a good thing because the market hates surprises and uncertainty breeds the need for higher risk premiums. For example, during the 1970s, the money supply was targeted, while today the target is inflation.

With all of the innovations in the financial industry since the 1970s, the definition of exactly what cash is has changed as well. For example, with the advent of credit and debit cards the need for actual paper money has decreased. Also, volatility is likely to remain lower in the cash market, an argument that is support by the fact that seven out of the 16 countries in the "Triumph Of The Optimists" study are now part of the euro and their monetary policy is dictated from Brussels. With fewer central banks, fewer things should go wrong. All of this makes unexpected inflation less likely, which makes the need for a higher risk premium for holding cash less likely as well.

Second, financial engineering has allowed for securitization and hedging capabilities that have never existed before. These developments have all made the markets more efficient and, therefore, a lower risk premium is required. For instance, when looking at IPS and regular government bonds of the same maturity, projected inflation can be forecasted for the economy.

Some critics argue, however, that inflation figures are not as accurate as they should be. For example, inflation figures do not take into account improvements in goods and services. Furthermore, substitution between goods is not well accounted for because countries are usually slow in adjusting the basket they use in inflation measurements like the consumer price index.

For instance, while the UK adjusts its basket of goods and services every year, the U.S. adjusts its basket only every 10 years. Another example is that the housing component of inflation in the U.S. is based on imputed rent rather than the cost of purchasing a house. However, while there is certainly room for improvement, the accuracy of today's inflation calculations has never been better. According to an Economist article titled, "A Short History Of Inflation" (1992), this is a big difference as, "typically, older indexes covered only included food and housing, and excluded services".

In general, the historical movement of inflation provides evidence that real rates of return on T-bills will revert closer to historical norms rather than what we experienced during the Great Bull Market. With better control over monetary policy and more efficient markets, the likelihood of high unexpected inflation and high risk premium is less likely. However, the value of T-bills as a risk-free benchmark will remain intact - without it, risk premiums can't be calculated and the allocation of capital become less efficient.

To learn more about the money market, read Getting To Know The Money Market, Money Market Mutual Funds and The Money Market tutorial.

Related Articles
  1. Economics

    These Will Be the World's Top Economies in 2020

    Discover the current economic forces that are anticipated to significantly shift the landscape of the world's most powerful economies over the next decade.
  2. Investing Basics

    3 Key Signs Of A Market Top

    When stocks rise or fall, the financial fate of investors change, as well. There are certain signs that can reveal a stock’s course, and investors don’t need to be experts to spot them.
  3. Fundamental Analysis

    Emerging Markets: Analyzing Colombia's GDP

    With a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
  4. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  5. Investing

    Asset Manager Ethics: Rules Governing Capital Markets

    The integrity of the capital markets needs to be kept at utmost importance for all investors. This article shows how to maintain the integrity while investing.
  6. Economics

    Is the U.S. Economy Ready for Liftoff?

    The Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
  7. Economics

    Open Market Operations vs. Quantitative Easing

    How does the Fed's implementation of Quantitative Easing differ from its more conventional open market operations?
  8. Investing Basics

    Reserve Bank of India Cuts Interest Rates

    On September 29, 2015, The Reserve Bank of India cut policy interest rates (or the repo rate) by a higher-than-expected 50 basis points, to stimulate domestic demand and to lower borrowing costs.
  9. Economics

    Why Deflation Is The Fed's Worst Nightmare

    The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war.
  10. Economics

    Oil Is Cheaper Than Bread In Venezuela...The Country Is In Chaos

    Venezuela is floundering, and the story has more to do with just the falling price of oil.
  1. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>
  2. Are mutual funds considered cash equivalents?

    Though all mutual funds are considered liquid assets, only certain funds are considered cash equivalents. What Is a Cash ... Read Full Answer >>
  3. Who decides when to print money in India?

    The Reserve Bank of India, or RBI, manages currency in India. The bank's additional responsibilities include regulating the ... Read Full Answer >>
  4. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>
  5. Why is my 401(k) not FDIC-Insured?

    401(k) plans are not FDIC-insured because they are typically composed of investments rather than deposits. The Federal Deposit ... Read Full Answer >>
  6. Is Japan an emerging market economy?

    Japan is not an emerging market economy. Emerging market economies are characterized by low per capita incomes, poor infrastructure ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!