Talk to older investors, and they'll tell you that one of their biggest fears is inflation. Yet it's been more than 30 years since the annual inflation rate was high enough to pose any substantial threat to the S&P 500 (^GSPC -1.79%) or the financial markets generally. To understand why people still pay attention to the inflation rate, it's important to know what effects inflation has on the economy in general and your wealth in particular.
The biggest threat: loss of purchasing power
If you've ever looked back with nostalgia at a time when a certain favorite thing cost a lot less than it does now, then you've seen the impact of inflation over the long run. Put simply, inflation slowly but surely saps the value of your hard-earned money. Even at a relatively low 3% inflation rate, prices double roughly every 25 years. Moreover, depending on your individual needs, your personal inflation rate might be much higher than the official Consumer Price Index. For instance, many retirees have argued that the CPI doesn't reflect their particular spending patterns, making it necessary to determine their own price-increase exposure and make arrangements accordingly.
The steady erosion of purchasing power is the biggest reason why investing too conservatively can be problematic. If you keep money in a savings account right now, you guarantee that your account balance will never go down. But earning just a fraction of a percent in interest, you'll never keep up with even the low inflation rate that we've enjoyed lately
How the inflation rate affects fixed-income investments
Investors in bonds and other fixed-income investments hate inflation, precisely because of the erosion of purchasing power that it causes. When the inflation rate rises, bonds that promise a fixed payout long into the future become less valuable, because the real value of that future payout is less if prices are increasing more quickly. One major reason why bonds have performed so well over the past 30 years is that the inflation rate went from double-digit percentages in the late 1970s and early 1980s to a negative number in 2009.
To protect bond investors, inflation-protected bonds have their future payouts adjusted by the inflation rate. You can buy the ETF iShares TIPS Bond (TIP -1.03%) and similar investments to get access to these inflation-protected bonds, whose value changes not due to inflation but rather due to changes in real interest rates drive by macroeconomic forces. But with traditional bonds, you retain the risk that inflation will hurt your portfolio.
The inflation rate and the stock market
For stocks, the impact of changes in the inflation rate is far less clear. Some stocks, especially high-dividend payers with low potential for growth, act much like bonds, and so their value tends to go down when the inflation rate rises. For instance, regulated utility companies American Electric Power (AEP -0.63%) and Duke Energy (DUK -0.39%) have to get approval for rate increases from regulators, limiting their ability to respond to higher prices as quickly as unregulated companies can.
On the other hand, many companies can react to higher costs by passing them through to customers. Companies whose brands have the highest value arguably have the easiest time passing through costs, and in some cases, the pricing power they have can actually lead them to get higher margins when overall price levels rise. For instance, Apple (AAPL -0.80%) has done a good job getting customers to pay premium prices for more memory, and if memory prices rose, Apple might be able to apply an even bigger markup on its larger-storage models of popular mobile devices.
Finally, stocks that focus on selling commodity goods can greatly benefit from inflation, if their particular commodity is what's causing the general rise in the inflation rate. Gold mining stocks are perhaps the best example of this phenomenon, as gold often reacts favorably to high rates of inflation, boost profits for companies that produce the yellow metal.
Be vigilant against inflation
The inflation rate appears likely to stay low for the foreseeable future, but that doesn't mean you should let down your guard. By knowing how inflation will affect you, you can be in a better position to handle whatever changes in the inflation rate come in the future.