By Molly Cyrus 
Introduction
Inflation risk is the chance that Inflation will eat away the value of an investment. In simple words as time passes Inflation reduces money’s purchasing power. This concept is crucial in finance because Inflation can have far reaching implications on personal finance as well as the overall economy.
For business it could be an increase in the cost of inputs thereby reducing profitability unless business prices are correspondingly increased. Policymakers controlling Inflation must then be balanced against the need to ensure that the economy is growing a point commonly addressed through monetary policy.
Different Factors of Inflation
Demand Pull Inflation
In this inflation basically demand for goods and services exceeds supply. Rapid growth in an economy or an increase in disposable income for a consumer leads the consumer to expend more thereby increasing the demand for goods and services. In such situations if supply cannot keep pace with increased demand prices increase due to Inflation. For instance during boom times in an economy demand inflation may occur as business establishments cannot cope with increased demand.
Cost Push Inflation
This inflation resulted from a rise in the cost of production. An increase in labour raw materials and energy inputs raises the prices of businesses inputs which is reflected in hiking up the prices for consumers. For instance the increase in oil prices translates into increased transport and productive costs which is transmitted upstream and virtually pushes up Inflation in all industries.
Monetary Inflation
In this Inflation money supply in the economy increases while the output of goods and services remains constant. There will be more money circulating with the same amount of goods and services in the economy. Every unit of currency will therefore depreciate and prices will go up.
Types of Inflation
Creeping Inflation
This is a mild inflationary movement but where the increase of prices happens slowly and so is easily predictable often at 13% a year. Creeping Inflation is viewed as normal and constructive for the economy as it promotes the expenditure of money and investments.
Walking Inflation
When the rate of Inflation runs between 3% and 10% per annum then it comes under walking Inflation. This boasts a clearer indication and negative effect on the purchasing power of money compelling consumers and businesses to seek their inflation protection.
Galloping Inflation
While Inflation above 10% a year is said to be galloping Inflation at such levels it becomes very troublesome for the economy technically eroding confidence in the currency and causing disturbances in investment and economic planning.
Hyperinflation
This is the highest extreme of Inflation where prices continue to rise uncontrollably and precipitously often more than 50% per month. Hyperinflation may eventually result in an economic collapse due to the loss of all value in currency.
How Inflation is to be Calculated?
There are a variety of price indices used to measure the price changes of a basket of goods and services over some period. These indices offer a number of ways in which policymakers businesses and investors can quantify inflationary risk and evaluate it in order to make informed decisions.
Producer Price Index (PPI)
In this measure the average changes over time in prices received by domestic producers for their products and services at different stages of production. The PPI is often considered a precursor indicator of consumer inflation since increases in input costs if sustained are likely to be passed on to consumers.
Personal Consumption Expenditures (PCE) Price Index
The PCE Price Index which the US Federal Reserve prefers measures Inflation as the change over time in the prices of goods and services purchased by households rather than fixed quantities of goods and accounting for expenditure rather than fixed quantities of goods.
Core Inflation
Core inflation accounts for volatile items such as food and energy hence it is used to track the stable flows of underlying trends in Inflation. Its usage is especially important in monetary policy decisions for the central banks since it outlines longrun inflationary pressures without reflecting on short run variability.
Inflation Risk And Impact on Asset
Inflation risk varies across asset classes. Understanding how inflation influences these assets enables investors to manage their portfolios and mitigate the negative impact of inflation on asset values.
Bonds
Bonds are relatively sensitive to Inflation because they involve fixed dollar interest over a period. Higher Inflation reduces the buying power of fixed payments hence making bonds less attractive to investors. For instance when Inflation increases to 5% and a bond accrues a fixed interest rate of 3% per year that bond delivers a negative real return of (2%). Thus inflation risk is relatively high with long term bonds since they fix a payment for quite a period.
This risk is mitigated by the inflation protected securities available in various countries including TIPS in the United States. TIPS are instruments whose principal value is adjusted with changes in the CPI to safeguard the purchasing power of the investor.
Equities
Stocks offer some inflation protection. If a company feels that costs are rising it can pass this on to consumers by raising prices. In theory as Inflation rises companies with pricing power can maintain profit margins. As such stock prices tend to reflect increases in Inflation. Not all companies are equal however in resisting Inflation.
Companies that have high input costs and those that are part of price sensitive industries are less able to pass along cost increases in the form of increases in price and profitability is affected. Besides Inflation can negatively affect the equity market by pushing up interest rates if the central bank reacts to curb Inflation by raising interest rates.
The resultant rise in interest rates increases the borrowing cost faced by the firms and decreases the consumers consumption which may lead to reduced corporate profits and correspondingly lower equities.
Real Estate
Thus real estate is considered to be an inflation hedge as its value increases or its rentals increase due to Inflation. The prices of the construction materials and labour itself will escalate during inflation periods and hence such properties will increase in value. Inflation also facilitates the landlords ability to increase rents which have an equivalent purchasing power income stream.
However real estate is not immune to the risk of Inflation. If Inflation increases it may drive up interest rates raising the cost of borrowing for real estate investors and likely depressing demand for properties and prices.
Commodities
As commodity prices tend to go up in inflationary periods commodity prices often are viewed as an inflation hedge. The price of raw materials including both goods and services increases with every increase in Inflation. An example would be gold which has traditionally acted as a store of value during times of Inflation and is perceived as a stable asset that does not lose its purchasing power over time.
However commodity price volatility may not be equal and not all commodities perform well during the inflation period. Agricultural commodities are sensitive to weather conditions whereas energy prices are sensitive to geopolitical factors.
Means of Controlling Inflation Risk
Since Inflation can impact asset classes in varied ways investments therefore need to have measures in place so that the portfolios do not experience severe damage from inflation risk. The following are some of the strategies commonly applied in managing inflation risk.
Diversification
One of the best ways to reduce inflation risk is through diversification. In holding a mix of asset classes such as equities bonds property and commodities the investor will spread out his risk and then reduce the impact of Inflation on his portfolio. For instance while Inflation reduces the value of the bond the profits on equities or property may balance them out and give an average yield.
Inflation Linked Bonds
Inflation Linked bonds such as TIPS are tailored to address the problem of Inflation. These bonds adjust their principal in response to changes in CPI so that Inflation doesnt reduce the buyers purchasing power. The interest rate for inflation linked bonds might be lower compared to normal bonds but they prevent any erosion in investors purchasing power through Inflation hence they are ideal investments during inflationary periods.
Real Assets
Invest for example in real assets which include property commodities and infrastructure. The value of such assets is appreciated by inflationary pressures thus maintaining their real value. For instance the rents from real estate can be adjusted according to Inflation and commodities like gold tend to appreciate during inflationary times.
Equities with Pricing Power
Invest in price power companies. Companies that can raise prices without losing customers are less susceptible to inflation risk in inflationary times. Companies in staple industries or with brand loyalty tend to lose fewer customers when prices rise. Consumer staples healthcare and utilities industries are sectors containing companies with some degree of price power.
Floating Rate Debt
Floating rate debt instruments such as an ARM or a floating rate bond pay interest that floats with market interest rates. Such instruments can be useful against Inflation because interest always rises with Inflation and the returns for such investments ensure that they track Inflation.
Inflation Hedging Derivatives
Investors can also utilise derivatives such as inflation swaps or options to hedge against inflation risk. An inflation swap is a type of swap product in which an investor takes a fixed stream of payments for a payment stream indexed by Inflation thus creating a hedge on rising prices. Options on commodities or inflation linked securities can also create a protective asset under inflationary conditions by allowing investors to realise gains from price increases.
Role of Central Banks in Inflation
The role played by central banks in managing inflation risk by monetary policy is critical because it controls interest rates and by extension the money supply. Central banks need to keep the level of Inflation stable for the economy to grow but actions such as those that raise or lower an inflation risk for investors and businesses may be taken by the central bank.
Interest Rates and Inflation
The other major instrument utilised to control Inflation is adjusted interest rates. When the rate of Inflation gets too high the central bank will raise the rate at which interest is being charged so that borrowing costs increase which in turn slows down the economy. Conversely when the inflation level is low or low the economy has been experiencing a recession. Hence money injection to boost spending and investment can be made by lowering interest rates.
These yield shifts are taken directly from interest rate changes and impact inflation risk for most asset classes. For example higher interest rates would adversely affect bonds by reducing relative attractiveness with increased borrowing costs further antagonising real estate and equity markets.
Quantitative Easing and Inflation
After an economic crisis such as that in 2008 or more recently the COVID19 pandemic central banks have always employed quantitative easing (QE) as a policy tool to inject liquidity into the economy. It includes buying government and corporate bonds increasing the money supply and driving down the long term interest rates. While QE may help revive the economy it also has the potential to invite future Inflation because an expanded money supply may one day bring up prices.
Supply Chain Disruptions and Inflation
Global supply chains which had never experienced such shocks in their history also witnessed unprecedented disruptions which materialised into input shortages and price hikes. As the economies open up and demand accelerates such supply chain bottlenecks have further added fuel to inflationary forces. For instance shortages of chips for semiconductors have pushed electronics and auto prices up while labour shortages in key sectors have added upward momentum to wage Inflation.
While some of these inflationary pressures may be transitory the danger is that supply chain disruptions could persist especially if variants of the virus or geopolitical tensions flare up anew.
Fiscal Stimulus and Inflation
Indeed governments around the world responded to the pandemic by undertaking large scale fiscal stimulus programs in the form of huge outlays and transfers targeted to households and businesses. These were necessary to avoid an economic meltdown but have also fueled inflationary pressures that arise from supply being outdone by demand.
For example in a liberalised regime without any caps on transfer or contingent liabilities the United States incurred enhanced unemployment benefits direct stimulus payments and increased infrastructure spending. Whether these fiscal policies will have a long run impact on inflation remains uncertain. Still the risk of chronic inflation is certainly a cause of concern for both investors and central banks.
Changes in Consumer Welfare and Inflation
The pandemic has altered consumer behaviour while the demand for other commodities and services that people cannot suddenly live without has accelerated Inflation such as equipment for home offices electronics and housing. On the other hand lower demand for travel hospitality and entertainment has complicated the inflation landscape.
In the post pandemic world normalisation of consumer behaviour might result in changes to risks emanating from Inflation in areas where some areas will exhibit downward pressure on prices. In contrast others will continue to face upward pressure.
Emerging Markets and Inflation Risk
Emerging markets which are more susceptible to inflation risks due to political instability and high commodity dependence with less developed financial markets are mainly exhibiting the type of market. Often the inflation rates of such countries are higher than those of developed economies and this can threaten their growth prospects and pose significant risks for investors.
External Shocks and Currency Depreciation
External shocks to the emerging economy like global commodity price fluctuations or outflows of foreign capital are easy to detect. For instance hyperinflation in Argentina and Venezuela was caused by both fiscal mismanagement and political instability that over time made both currencies worthless and destabilised the economies.
How it Affects Foreign Investors?
Foreign investors in emerging markets therefore are very wary about this inflation risk. Currency devaluation associated with high rates of Inflation would therefore lead to a significant diminution of the real value of return for the foreign investor. As Inflation increases central banks in these nations will therefore raise interest rates to tame the price level however such an increase has a slow motion effect on economic growth thus creating a delicate balance policymakers face.
Investors are generally aware of these kinds of risks and may hedge their exposures using foreign exchange derivatives or diversify into safer assets.
Income Inequality and Social Instability
The second reason is that in emerging markets inflation risk makes income inequality worsen affecting the lower income populations which spend more of their income on essential goods. As Inflation rises concerning food and fuel prices social unrest increases and consequently political instability does as well.
Psychological Effects of Inflation on Consumer
It relates to the extent to which the economic fundamentals of markets can affect a given market and the way in which behaviours can manifest in consumers. When Inflation increases this usually aligns with lower consumer sentiment but can divert spending trends. Behavioural finance emphasises that Inflation creates perceptions of ambiguity and fear for consumers such that their behaviours are altered for the worse in regard to how they impact the economy.
Conclusion
The most significant risk inflation is still a live threat both to mature and emerging economies. It continues to influence investment and overall economic stability worldwide. In order to shield one’s portfolio from such risks one demands flexible strategies depending on a particular problem volatility in emerging markets and novel patterns of consumption behaviour prompted by inflation in a different context.
It is therefore from this understanding of the psychological impact of inflation on consumer spending behaviours and the vulnerabilities of emerging markets that investors and policymakers will be better equipped to contend with inflationary pressure. International economies are surfacing. Hence there is a need to balance risk management in relation to inflation between traditional and innovative financial instruments.
Diversification in investments proper fiscal policies and strategic planning will determine long term financial stability in predictability and mitigating inflation related risks.