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 that 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.