Inflation, in simple terms, means the loss of a currency unit's purchasing power over time, which shows up as a continuous, general rise in the price of goods and services. Inflation isn't just a number in a statistics report; it's a kind of “hidden tax” that melts your wealth away if your assets don't grow to keep pace with it.
Inflation and purchasing power
When annual inflation is, say, 15%, it doesn't mean everything has become exactly 15% more expensive; it means your cash's purchasing power has fallen by 15%. If you keep $1,000 in cash untouched, with 10% inflation, you'll still have the same $1,000 at the end of the year, but its real value will equal $900 from the year before. So the first step in every investing principle is to preserve your purchasing power against inflation, and only then to earn a real return (a return higher than the inflation rate).
The chain reaction: inflation, the central bank, and interest rates
Central banks are enemy number one of high inflation, and their main tool for suppressing it is raising interest rates. This chain works as follows: inflation rises and the economy overheats, the central bank responds by raising interest rates, demand falls because people borrow and spend less, and inflation is eventually tamed.
Investor behavior and inflation's effect on different assets
Cash and fixed-rate bonds are the biggest losers of high inflation, since they generate a negative real return. Gold and commodities are known as hard assets, and demand for them rises when inflation surges, since there's no way to print an unlimited amount of gold. In the stock market, powerful companies with pricing power that can pass costs onto customers suffer relatively little damage during inflation, while growth and tech companies that need cheap loans get hit hard. The real estate market is usually an excellent inflation hedge, since both a property's value rises with inflation and rents climb in line with it. Bitcoin, because of its fixed 21-million supply cap, is known by its proponents as “digital gold” and a tool against inflation caused by money printing; however, in the short term, crypto's heavy dependence on interest rates and liquidity can cause temporary crashes in the crypto market.
The most important variable every investor needs to calculate is the real rate of return, meaning an asset's nominal return minus the inflation rate. An investment is only truly profitable when this number is positive.