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23rd January 2019 | Flawiusz Pawluk | Financial Markets Expert

Inflation – how it works? How to protect your wealth?

The topic of inflation has been somewhat dampened by concerns associated with global economy, monetary and fiscal stimulation and low levels of inflation. However, this topic is still valid and it may affect any investment and savings plans in the future.

What is inflation? How does it work?

One definition describes inflation as a process of increasing the average price level within the economy. The effect of the process is a decrease in the purchasing power of a domestic currency, which means that the amount of goods that we can buy for a one currency unit decreases. Opposite to inflation is deflation.

Inflation is often measured as an annual percentage change in consumer prices. One of the most common inflation indicator involved in the investment process is the consumer price index (CPI).

CPI is a statistical estimator which measures changes in the price level of the market basket of consumer goods and services, which are purchased by households. The basket uses prices of the most representative items, whose prices are collected periodically e.g monthly, quarterly, calculated yearly etc. The annual percentage change in the CPI is used to measure inflation.

The basket of goods and services can change over a long-term period, therefore, the CPI is not a perfect indicator of inflation in the long-term analysis, however it is one of the basic indicators used to measure inflation.

One of the main and direct factors which affects the level of inflation is the money supply, i.e. the amount of money in the economical system (on the market). If there is too much money, inflation increases as the goods and services price rise. There are a number of reasons for this but one of the most important is the money creation. 

Money creation is the process by which the money supply of a country, economic or monetary region, is increased. The central bank and commercial banks are responsible for the creation of money within the economy. The central banks may introduce new money into the economy by purchasing financial assets or lending money to other financial institutions whilst the commercial banks role in the creation of money is by granting loans to their clients.

The central bank influences the level of money supply, regulating interest rates and affecting cost of money.By doing this, the central bank has an influence on inflation. This means in practice that a central bank or a central bank operating committee can raise and lower official interest rates, affecting the borrowing cost of bank loans.

When the central bank raises interest rates, the cost of bank loans rises but money supply decreases. For this reason, the level of inflation should decrease or there can be deflation. Goods/services prices should fall. And vice-versa, if interest rates are falling, the money supply increases meaning the level of inflation should rise and goods/services prices should also rise.

Savings!

The cost of money, the level of interest rates, the increase/decrease in the goods and services prices has a direct impact on our savings.

When there is an increase in the prices of goods and services in the economy, i.e. inflation increases, then savings lose value if they are not invested. 

Investors who care for their savings should invest in assets that give a higher rate of return than inflation, so as to increase the real value of the money they have. It is important to be aware that if you choose a savings account or a bank deposit, this does not necessary mean that the profits will cover the cost of inflation. What to do then?

During high inflation, it is worth considering instruments that give higher than average rate of returns, such as, stocks, bonds indexed by inflation, or corporate bonds. A good solution would also be floating-rate-coupon bonds, whose coupon on bonds rises with the increase of interest rates. But the investor should remember that a higher rate of return may be associated with a higher level of risk.

High inflation is often associated with a good situation in the economy. In the case when the cycle changes and the economic situation of the country begins to deteriorate, fixed-coupon bonds would be a good solution. It should be remembered that the profitability of the fixed-coupon bonds rises following expectations in interest rates. If interest rates are rising, yields on fixed-coupon bonds should also rise. If interest rates are falling, yields on fixed-coupon bonds should also decrease.

If interest rates are on high levels, bond yields should be high, too. The economic weakening of the country means that inflation may fall in the future. It also means that buyers of goods and services will buy less in the future, and thus inflation may be lower. In such a situation, the central bank may counteract by the reduction of interest rates (rates cut) in order to reduce the cost of money and thus increase its supply to support trade market and economy. It is worthwhile buying fixed-coupon bonds in a situation when their profitability is high, expecting alternatives of low-yielding bonds in the future.

The bottom line

However, it should be remembered that the above rules are just examples, and earning money is a complicated and difficult process. There are no simple solutions or answers. The market remains mobile whilst struggling to meet supply and demands. Different reasons to invest imply different behaviors, often irrational and inflation values andexpectations of inflation in the future can differ. 

In order to achieve the benefits from a rate of return higher than the level of inflation and to limit the investment risk, it is worth building a portfolio of financial assets.

Therefore, it is worth considering assistance from specialists within our portfolio management team who have the knowledge and experience in the investment area.

​​​​​​​Notice: Golden Sand Bank ("Bank") exercised due diligence to ensure that the information contained in this publication was not incorrect or untrue as at the date of publication. All Investment products are at risk, as their value can go down as well as up. The tax treatment of your investment will depend on your individual circumstances and may change in the future. If you are unsure about whether investing is right for you, please seek financial advice. This publication is not an investment recommendation or investment advice in connection with any services provided by the Bank to the Client.

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