A:

Inflation is typically defined as a sustained increase in the price level of goods and services. There is no widespread consensus on the primary cause of inflation, but most economists agree that certain mechanisms in the economy, mainly commodity price increases and currency depreciation, contribute strongly to it. Inflation has the potential to significantly reduce the return on fixed-income investments, and investors should monitor its effect on their assets.

The real interest rate incorporates the effect inflation has on an investment. For example, a bond’s nominal interest rate does not take inflation into account, and an investor will only earn that amount in accumulated value when inflation is zero. A bond’s real interest rate, which indicates the investor's actual gain or loss, is calculated by subtracting inflation from the nominal interest rate. For example, if the nominal interest rate is 4% and inflation is 3%, the real interest rate is 1%. If inflation is higher than the nominal interest rate, the bondholder will take a loss. As many investors rely on bonds as a predictable source of income, they can take significant losses during periods of high inflation.

One of the most problematic aspects of inflation is that its impact on investments is not stated explicitly, so the investor must monitor it him/herself. There are two main inflation indicators: the Producer Price Index (PPI) and the Consumer Price Index (CPI). The PPI consists of prices of consumer goods and capital goods paid to producers (mostly by retailers), and inflationary trends are reflected earlier than they are in the CPI, so the PPI can be useful to investors as an early signal. The CPI solely includes retail prices, though it is much more widely followed than the PPI. When economists talk about rising inflation, they are usually referring to a rise in the CPI.

RELATED FAQS
  1. How does the Fisher effect illustrate returns on bonds?

    Learn how the Fisher effect shows the impact of expected future increases in inflation on the prices of bonds and their interest ... Read Answer >>
  2. What is the difference between the consumer price index (CPI) and the producer price ...

    Learn how the PPI and CPI differ in the composition of their target sets of goods and services and the types of prices collected ... Read Answer >>
  3. What is inflation and how should it affect my investing?

    Inflation, an economic concept, is an economy-wide sustained trend of increasing prices from one year to the next. The rate ... Read Answer >>
  4. What's the highest year-over-year inflation rate in the history of the U.S.?

    Learn about periods with the highest inflation in U.S. history and the mandated role of the U.S. Federal Reserve in controlling ... Read Answer >>
Related Articles
  1. Insights

    A Primer On Inflation

    Inflation has a negative connotation, but is it all bad or does it offer some tangible benefits?
  2. Investing

    Interest Rates Explained: Nominal, Real, Effective

    Interest rates are divided into subcategories. Smart investors look beyond the nominal or coupon rate of a bond or loan to see if it fits their objectives.
  3. Insights

    Should You Worry About the U.S Inflation rate?

    Understand how inflation is measured, how U.S. inflation compares to other countries, and if investors should be concerned with rising inflation.
  4. Insights

    What You Should Know About Inflation

    Find out how this figure relates to your investment portfolio.
  5. Investing

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
  6. Financial Advisor

    Corporate Bonds and the Impact of Inflation Risk

    The impact of inflation risk affecting corporate bond returns can be significant. It may even result in a real loss of purchasing power.
  7. Investing

    What Causes Inflation in the United States

    Inflation is the main catalyst behind U.S monetary policy. But what causes this phenomenon of sustained rising prices? Read on to find out.
  8. Investing

    Retirement Planning: Why Real Rates of Return Matter Most

    Here's how to plot your real rate of return, understand your "personal inflation rate" and safeguard your retirement funds against inflation.
  9. Insights

    What's a Real Rate of Return?

    A real rate of return is an annual percentage investment return that’s adjusted for inflation, taxes or other factors.
RELATED TERMS
  1. Real Interest Rate

    An interest rate that has been adjusted to remove the effects ...
  2. Inflation Protected

    The types of investments that provide protection against inflation ...
  3. Price Inflation

    Price inflation is the increase in a collection of goods and ...
  4. Inflation Targeting

    A central banking policy that revolves around meeting preset, ...
  5. Inflation-Protected Security - IPS

    A type of fixed-income investment that guarantees a real rate ...
  6. Inflationary Risk

    The uncertainty over the future real value (after inflation) ...
Hot Definitions
  1. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  2. Whole Life Insurance Policy

    A life insurance contract with level premiums that has both an insurance and an investment component. The insurance component ...
  3. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  4. Capital Asset Pricing Model - CAPM

    A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. ...
  5. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability of potential investments.
  6. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
Trading Center