What does inflation mean? Understand the pattern of rising prices and seize investment opportunities amid economic changes.

What exactly does inflation mean? Simply put, inflation means your money is becoming less valuable over time. When prices keep rising during a certain period, you can buy less with the same amount of money. This is inflation, or what we often call “inflation.”

In the past two years, global inflation pressures have not eased, and central banks around the world have been raising interest rates. Taiwan’s central bank has even increased rates five times in a row. How should ordinary investors respond to inflation? This article will start from the essence of inflation, help you understand the logic behind this phenomenon, and show you how to find investment opportunities amid inflation.

What does inflation mean? Measured by CPI

The most commonly used indicator to judge inflation is the Consumer Price Index (CPI). Taking Taiwan as an example, the CPI intuitively reflects changes in residents’ living costs. When CPI continues to rise, it means you need to spend more money to buy the same goods.

How does inflation occur? Four major factors revealed

To understand what inflation means, first know how it comes about. The fundamental cause of inflation is: the amount of money circulating in the market exceeds the actual quantity of goods. Too much money chasing too few goods ultimately leads to rising prices.

Demand-pull inflation
When consumer demand suddenly increases, businesses can’t keep up with production, leading to shortages and rising prices. In this situation, corporate profits increase, which further stimulates investment and consumption, forming a virtuous cycle. The economy (GDP) also grows accordingly. That’s why governments want to stimulate demand.

Cost-push inflation
Rising raw material prices also drive inflation. During the Russia-Ukraine conflict in 2022, Europe’s energy supply was disrupted, and oil and gas prices soared tenfold, causing the Eurozone CPI annual growth rate to exceed 10%, reaching a record high. This type of inflation can drag down economic growth and even lead to GDP decline.

Excessive money supply
Unrestrained money printing by governments directly causes inflation. Most hyperinflations in history stem from this. Taiwan experienced this in the 1950s: to cover post-war deficits, the Bank of Taiwan issued大量貨幣, resulting in 8 million法幣 only worth 1 USD.

Inflation expectations
Once people expect prices to keep rising, they rush to spend, demand higher wages, and businesses raise prices accordingly, creating a vicious cycle. Once inflation expectations form, they are hard to reverse. That’s why central banks emphasize firmly suppressing inflation.

How does raising interest rates curb inflation?

When inflation rises, central banks usually raise interest rates. Higher rates mean higher borrowing costs. For example, from 1% to 5%, the annual interest on a 1 million loan increases from 10,000 to 50,000. As a result, the public is less willing to borrow for consumption and prefers to keep money in banks.

Demand decreases → goods become sluggish → companies lower prices to stimulate sales → prices fall. This is the logic behind rate hikes suppressing inflation.

But it comes with a cost: sluggish demand leads to layoffs, rising unemployment, slowing economic growth, and possibly triggering an economic crisis. That’s why central banks need to be cautious when raising rates.

Moderate inflation can actually be beneficial

It may seem that inflation is all bad, but moderate inflation is actually beneficial to the economy.

When people expect future goods to rise in price, they are motivated to spend. Increased demand promotes corporate investment, increases output, and the economy grows. China in the early 2000s is an example: CPI rose from 0 to 5%, and at the same time, GDP growth jumped from 8% to over 10%.

Conversely, deflation (negative inflation) is a disaster. After Japan’s economic bubble burst in the 1990s, it fell into deflation, with stagnant prices, consumers saving rather than spending, negative GDP growth, and ultimately a “Lost Decade” of 30 years.

Therefore, most central banks set inflation targets within a reasonable range. Developed countries like the US, Europe, and Japan target 2%-3%, while most other countries aim for 2%-5%.

Who benefits from inflation?

Inflation harms those holding cash, but it is especially advantageous for debtors.

Imagine you borrowed 1 million 20 years ago to buy a house. With a 3% inflation rate, after 20 years, the real value of that 1 million is only about 550,000, meaning you only need to repay half of the original debt. So during high inflation periods, those who buy assets (real estate, stocks, gold, etc.) with debt profit the most.

The dual impact of inflation on the stock market

Low inflation period: bullish for stocks
Hot money flows into the stock market, pushing stock prices higher.

High inflation period: suppresses stocks
Central banks adopt tightening policies, raising interest rates, increasing corporate financing costs, and lowering stock valuations.

The 2022 US stock market is a vivid example. In June, the US CPI hit 9.1%, a 40-year high. The Fed started raising rates in March, with a total of 7 hikes amounting to 425 basis points throughout the year, pushing rates from 0.25% to 4.5%. As a result, the S&P 500 fell 19%, and the tech-heavy NASDAQ plunged 33%.

But high inflation periods are not entirely unproductive. Energy stocks often perform well. In 2022, the US energy sector returned over 60%, with Western Petroleum up 111% and ExxonMobil up 74%.

How to allocate assets during inflation?

In an inflationary environment, relying on a single asset class can lead to concentrated risk. The correct approach is to build a diversified investment portfolio to spread risk.

Performance of various assets during high inflation:

Real estate: When liquidity is abundant, large capital flows into property, driving up prices.

Precious metals (gold, silver): Gold tends to perform inversely to real interest rates (real interest rate = nominal rate - inflation rate). The higher the inflation, the better gold performs.

Stocks: Volatile in the short term, but generally outperform inflation over the long term.

Foreign currencies (USD): When central banks raise interest rates, the USD appreciates, providing a natural hedge against inflation.

A simple allocation plan is: Divide your funds into three parts, each 33%, investing in stocks, gold, and USD respectively. This way, you can enjoy the growth potential of stocks while hedging inflation risks with gold and USD.

Summary

What does inflation mean? Ultimately, it’s the devaluation of money. Low inflation can promote economic growth, while high inflation damages the economy. Central banks combat high inflation by raising interest rates, but this also risks slowing down the economy.

In facing inflation, investors need not panic. The key is to understand the essence of inflation, and adjust asset allocation flexibly according to different economic stages. By reasonably distributing assets among stocks, gold, USD, real estate, and others, you can effectively counteract the erosion of wealth caused by inflation and even find opportunities for growth.