Inflation Risk

Risk of decrease in value due to unanticipated inflation.

Author: Zezhao Fang
Zezhao Fang
Zezhao Fang
I hold a degree in Statistics from the University of Waterloo. As a graduate, my academic focus has equipped me with strong analytical and quantitative skills. While I currently do not have a specific profession or work experience, my education has honed my abilities in statistical analysis, data interpretation, and problem-solving. I am well-versed in various statistical methods and techniques, making me adept at deriving meaningful insights from data.
Reviewed By: Christopher Haynes
Christopher Haynes
Christopher Haynes
Asset Management | Investment Banking

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds asset management firm with $20 billion under management, and as an investment banking analyst in SunTrust Robinson Humphrey's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Last Updated:October 31, 2023

What Is Inflation Risk?

Inflation Risk, also known as "purchasing power risk," is the possibility that a bank's costs will increase or its actual returns will decrease due to inflationary factors.

Inflation also causes the real return on bank assets to decline. The real rate of return on assets is equal to the nominal rate of return on assets minus the inflation rate. The higher the rate of inflation, the lower the real rate of return on assets. 

When the inflation rate is higher than the nominal rate of return on assets, the real rate on assets becomes negative, and the real purchasing power of assets decreases instead. Therefore, from the perspective of assets, inflation is an "invisible tax" for banks.

Purchasing power risk is primarily a factor of inflation. This, in turn, is very closely related to the interest rate factor. If interest rates do not keep up with inflation, investing in money market funds will naturally make the income less and less valuable. 

If the income growth rate is lower than the inflation rate for investments in other funds, you will also suffer from purchasing power risk.

This means that the Fund's profits will be distributed primarily in cash, the purchasing power of which may be reduced by the effects of inflation and currency depreciation. 

As a result, the Fund's real returns are reduced, creating the risk that investors will experience lower levels of real returns.

Purchasing power risk is different from interest rate risk and market risk. This is because investors risk losing purchasing power in the event of sustained price increases. 

Many investors mistakenly believe that more money will make them richer, and this monetary illusion causes investors to ignore the problem of inflation. Investors can only overcome the currency illusion problem by focusing on real yields rather than nominal yields. 

And purchasing power only improves when the real rate of return is positive, i.e., when the nominal rate is greater than the inflation rate.

Reasons For Inflation Risk

Inflation is a phenomenon in which the purchasing power exceeds the supply of output because the supply of money is greater than the actual demand for money, resulting in a depreciation of the currency and, thus, a sustained general increase in prices over some time. 

The main reason is that the total social demand is greater than the total social supply and the amount of money issued exceeds the amount needed in circulation.

Under normal circumstances, inflation directly depreciates the common currency's value in circulation in the market. 

If the income of the population remains unchanged, the standard of living decreases, leading to the disruption of social and economic life, which is detrimental to economic development. 

In the market, the inflation rate (CPI) is a macroeconomic indicator that reflects changes in the price level of consumer goods and services related to the population's life. 

This indicator is mainly used for macroeconomic analysis and decision-making as well as an indicator of national economic accounting. 

Under normal circumstances, if the economic index of the inflation rate (CPI) increases significantly, there may be inflation in the market, leading to instability in the market economy.

Demand-pull inflation is caused by the growth of aggregate social demand exceeding the growth of aggregate social supply, resulting in a shortage of supply of goods and services and a sustained increase in prices. It is characterized as spontaneous, induced, and supportive.

Cost-push inflation is also known as cost inflation and supply inflation. It refers to a significant increase in general prices due to an increase in supply-side cost prices and occurs in the absence of special demand.

Import inflation is the phenomenon of increasing domestic prices due to the increase in the prices of foreign goods and factors needed for their production, which can also be said to be caused by the exchange rate.

Structural inflation is a phenomenon in which the prices of some commodities increase due to excessive demand for certain types of products, despite the low overall demand.

Types of inflation risk

In different economies, there are different causes. For example, in Keynesian economics, inflation is caused by a change in the price level due to changes in aggregate supply and aggregate demand in the economy. 

In monetarist economics, it arises because when the amount of money issued in the market exceeds the amount of money needed in circulation, there is a devaluation of the currency, and prices rise, leading to a decrease in purchasing power.

Inflation means that the real demand for money is less than the supply of money under the conditions of money circulation. 

In other words, the real purchasing power is greater than the supply of output, which leads to a devaluation of the currency and causes a general increase in prices for some time. The essence is that the total social demand is greater than the social supply. 

Inflation will lead to price increases so the early stages will lead to gold price increases. After that, however, a period of high inflation and decline will lead to gold prices falling.

Generally speaking, we can classify inflation according to its sharpness.

Low inflation, characterized by slow and predictable price increases, can be described as single-digit inflation at an annual rate of 1 when prices are relatively stable and people have more trust in money.

Sharp inflation: this type of inflation occurs when the total price level rises at a two or 3-digit rate of 20%, 100%, or even 200% per year. Once this inflation develops and stabilizes, serious economic problems can occur.

Hyperinflation is the most harmful type of inflation, where money has almost no fixed value on the mountain, and prices keep rising, with disastrous effects on the market.

Impact of Inflation Risk

Inflation has two very different effects on the price of securities. First, at the beginning of inflation, the book value of fixed assets of companies and businesses, such as real estate, machinery, and equipment, increases.

Higher prices allow companies to sell their inventory at higher prices and profit from raw materials that they previously purchased at lower prices. 

The increase in the value of nominal assets and earnings will increase the market price of the company's stock. At the same time, in anticipation of inflation, people will rush to buy stocks to preserve their value, stimulating a brief increase in stock prices.

However, when inflation continues to rise for some time, it reverses the trend of stock prices and negatively affects investors. As a result, the false value of the company and corporate assets are exposed. 

New production costs increase due to higher prices of raw materials and other materials. As a result, corporate profits decrease accordingly, and investors begin to sell their stocks and look for other ways to preserve the value of their financial assets. 

This will be a shrinking demand in the stock market, with supply outstripping demand, and stock prices will naturally fall sharply. 

Severe inflation will also depreciate the value of investors' stock holdings, reducing the real purchasing power of the monetary income derived from the sale of stocks.

The first affected by inflation are workers and farmers, which is a serious disaster. This is because inflation causes prices to keep rising and the purchasing power of money to keep falling. 

This, in turn, causes a sharp decline in real wages for workers, resulting in increasing poverty. The peasants, the small producers, were forced to buy capital at high prices because of the rising prices and the expanding prices of industrial products. 

So the peasants had to buy capitalist industry at high prices to buy the products produced by capital and sell their agricultural and handicraft products at low prices. This creates a vicious circle of poverty.

Inflation also affects the lives of those who work. Their salaries do not rise because of the increase in prices. However, inflation brings significant benefits to the monopoly bourgeoisie

Not only will they transfer into their own pockets most of the income that the bourgeois state has plundered from the working people with indiscriminate paper money, through government orders and price subsidies, etc. 

And they can take advantage of the fall in real wages or pay off their debts with devalued currency, and some even take advantage of the soaring prices to hoard large quantities of goods for huge profits.

Protecting against Inflation Risk

In the middle of inflation, the prices of valuable securities fall, so we can buy wealth management, gold bricks, silver bars, and stocks through regular banks to cope with inflation and ensure that their property does not depreciate.

1. Control the money supply

Since the immediate cause of inflation is an excess supply of money, one of the most basic countermeasures to control inflation is to control the money supply to accommodate money demand and stabilize the value of money. 

Thus, prices are stabilized. Therefore, it is necessary to implement a moderately tight monetary policy to control the money supply and maintain a moderate scale of credit to control the money supply. 

The central bank uses various monetary policy tools to flexibly and effectively regulate the total amount of money and credit to control the money supply at a level appropriate to objective demand.

2. Restructuring the economy

One of the causes of inflation is the imbalance in the economy's structure. Therefore, one of the measures to control inflation is adjusting the economy's structure. 

Maintain a certain ratio between industries and sectors, and avoid the supply and demand of some products such as food and raw materials to push up prices due to structural imbalance.

3. Increase supply

Inflation is controlled by reducing aggregate demand on the one hand and increasing aggregate supply on the other. 

The main measures are tax cuts: increasing the willingness of workers and labor productivity and increasing the desire of enterprises to invest, which leads to an increase in aggregate supply. 

Reduce government restrictions on enterprises to expand the supply of goods better. Encourage enterprises to adopt new technology, update equipment and adjust industrial structure. 

At the same time, the personal income tax rate schedule for expatriates will also be changed.

4. Other policies to treat inflation

In addition to controlling demand, increasing supply, and restructuring, there are restrictions such as prices, tax cuts, indexation, and other policies to control inflation.

To mitigate the negative impact of inflation on our lives, we should take active measures to offset the inflationary interest rates. 

In the early stages of inflation, we can buy a house through a bank loan. This method works when your income remains the same and the bank interest rate remains the same.

In the early stages of inflation, the demand for capital increases, and it is challenging to raise capital, so long-term debt should be acquired to keep the cost of the capital stable.

If the risk of currency devaluation increases in the middle stage of inflation, companies can also invest to hedge the threat and preserve the value of capital. 

Select long-term purchase contracts with stable customers to reduce losses from price increases. In addition, strict credit terms can be used to reduce claims.

Inflation Risk FAQs

Researched and authored by Zezhao Fang | LinkedIn

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