Deflactor: How inflation affects your wallet and investment strategy

Why did your salary go up but you earned less?

If in 2022 you received a salary increase but still felt that your money went further, you’re not alone. That is the effect of inflation in action. And this is where a concept many governments are starting to take seriously comes into play: the deflator.

When the prices of everything rise (from food to services), your purchasing power erodes. That is, although you earn more money nominally, you can actually buy fewer things. In Spain, inflation reached 6.8% in November 2022, a level not seen in decades. To combat this, central banks raise interest rates, slowing credit and spending to contain the price spiral.

What exactly is the deflator?

In simple terms: the deflator is a tool that removes the “noise” of inflation to see the economic reality. It compares the nominal value (what the numbers say) with the real value (what it is actually worth considering price changes).

A practical example: A country produces goods worth 10 million euros in year 1. In year 2, production rises to 12 million. It seems like a 20% growth, right? But if prices also increased by 10% between the two years, the real growth is only 10%. That is deflating: removing the effect of inflation to see what really happened.

Economists use the deflator to compare economic variables over time: Gross Domestic Product (GDP), wages, company sales. Without this correction, it’s impossible to know if an economy truly improved or just experienced inflation.

Deflating the IRPF: The fiscal battle against inflation

In Spain, local and national politicians have been debating a measure called “deflating the IRPF” for months. What is it about?

The IRPF (Personal Income Tax) is progressive: the more you earn, the higher percentage of taxes you pay. The problem arises when your salary increases due to inflation, not productivity. Without deflating, you automatically move to a higher tax bracket, losing purchasing power even if your salary barely covers the same as before.

Deflating the IRPF means adjusting those tax brackets so that inflation doesn’t push you into paying more taxes. If your salary increases by 5% but inflation is 6%, deflating prevents you from paying taxes as if you had actually earned more money.

Why do other countries already do it? In the United States, it is deflated annually. The same happens in France and Nordic countries. Germany does it every two years. In Spain, at the national level, it hasn’t been done since 2008, although some autonomous communities are considering implementing it.

The dilemma: Who benefits and who loses?

Proponents of deflating the IRPF argue that it is fair: it protects families’ purchasing power during inflationary crises. However, critics point out three problems:

First, inequality: The wealthy benefit more because they are in higher brackets. A 5% deflation benefits someone earning 100,000 euros much more than someone earning 20,000.

Second, the economic effect: If people maintain their purchasing power, they continue spending the same, which can keep inflation high. To slow it down, sometimes demand must be reduced, even if it hurts.

Third, fiscal impact: Less revenue for the State could mean less funding for education, healthcare, or infrastructure.

How to invest when everything rises in price

Inflation and high interest rates create a challenging environment for investing. But not impossible. Here are several options depending on your risk profile:

Gold and commodities

Gold is the classic refuge. When the currency loses value, gold tends to maintain or increase its value because it’s not tied to any specific economy. Long-term, it has historically always gone up. The problem: it is volatile in the short and medium term. In 2022, we saw how government bonds offered yields adjusted for inflation, but gold remained attractive for those seeking protection.

Stocks: the balance between risk and opportunity

High inflation and elevated interest rates generally harm the stock market. Companies have to borrow more expensively, margins contract, stock prices fall. 2022 was an example: the tech sector plummeted while energy companies posted record profits.

But here’s the key: in an inflationary recession, there are opportunities. If you have liquidity and a long-term horizon, you can buy stocks at low prices. Markets have always recovered historically, even after brutal declines. Companies that sell products or services with constant demand (energy, food, basic services) withstand better than others.

Currencies: high risk, high potential

When inflation is high, the local currency depreciates. This can be an opportunity: buy foreign currencies that appreciate in value. But the forex market is highly volatile and requires experience. Leverage can multiply both gains and losses with small investments. It’s not for beginners.

Diversification: your best shield

Inflation does not affect all assets equally. That’s why diversification is key: combine stocks, bonds, gold, real estate, currencies. This way, you protect your portfolio across different market scenarios and reduce risk.

The impact of deflating the IRPF on your investments

If deflating the IRPF were implemented, taxpayers would have more disposable income. That could mean:

• More money to invest: After-tax returns would be higher, especially in income-generating investments (stocks, real estate).
• Reallocation of funds: If deflating includes incentives for certain sectors (green energy, technology), there will be more investment there.

However, realistically: the average economic benefit is not spectacular. Someone with average income would save just a few hundred euros. It’s not a panacea that will revolutionize national investment.

What you should know before investing

The reality is that no investment is risk-free. During times of inflation and high interest rates:

• Historic assets (stocks, real estate, commodities) have offered positive long-term returns but with short-term volatility.
• Treasury bonds offer safety but reduced yields if inflation remains high.
• You must consider how taxes (IRPF) will affect your real gains.

The deflator, both as an economic concept and fiscal tool, is just a piece of the puzzle. It doesn’t solve inflation, but it can help prevent your purchasing power from crumbling while you wait for the economy to stabilize. As an investor, the key remains the same as always: diversify, think long-term, and don’t panic over short-term fluctuations.