What’s inflation and why does it affect your investments?

For context:

On Wednesday the US Government announced that US inflation in April had risen to 4.2% over its level a year ago. But what is inflation and why has this announcement had a knock on effect on markets? Stick with us – we’re about to tell you.

What is inflation?

Inflation is the rate at which the prices for goods and services increase. Not to get too maths-y but it’s expressed as a percentage increase in prices over time. In real terms, say the new TV you bought this January for lockdown Netflix binges cost £350, 2% annual inflation means that next year, the same television will cost £357.

Inflation effectively decreases the value of your money. The higher the rate of inflation, the less you will be able to buy with the same amount of money in the future – especially if the rate of inflation is higher than the interest rate your bank pays you on your savings account.

Inflation is typically seen as a good thing in economic terms. If people see that prices are going up, it can help encourage them to spend sooner which fuels further economic growth.

The UK and US both have a target inflation rate of +/- 2% and try to keep it around that level using tools such as interest rates and taxes.

Why does it affect my investments?

Investors use inflation as an indicator of how the economy is performing. The 4.2% inflation rate announced this week suggests that the US economy is rebounding rapidly from the lows of 2020 when COVID-19 lockdowns were hitting spending.

This is usually a great sign for investors as a stronger economy should mean bigger profits for companies. This time should be no different, but some sectors of the US stock market dropped on the announcement. Why? Well, a healthy economy doesn’t need as much government support as a struggling one. The US Government has been pouring money into its economy to help support companies through COVID-19. Now things appear to be improving, the government is expected to reduce this support. Less government support could potentially impact companies’ profits and therefore their share prices – but the hope is that the economy is strong enough that companies shouldn’t have to worry about whether they receive government support or not.

What’s more, if inflation goes too high for too long then governments will maybe increase interest rates to try to slow things down. Higher interest rates mean more incentive to save for consumers rather than spend. They also mean higher costs of borrowing for both companies and consumers so raising them too quickly could bring the economy to a halt and hurt share prices.

What’s next?

Over the next few months, we’ll likely hear lots more about governments (not just the US) reducing their support packages as economies bounce back. Inflation has been way below target for years now though so governments won’t raise interest rates too quickly if it goes above target for a bit. On a short-term basis, announcements about inflation may result in drops in share prices on the day, or in the days after.

It’s important to remember the reasons though: the global economy is improving and companies no longer need government support. Short-term drops may create opportunities for investors who are prepared to think about the long term and invest when share prices are lower.

Remember: investing needs a long-term strategy – it’s about sticking to basic principles, blocking out the noise and staying with it for the longest time possible.

This article was first published on 14 May 2021. This article is provided for information only and does not constitute financial advice. If you require financial advice please approach an independent financial advisor authorised by the FCA. tickr does not provide financial advice and is an execution only platform.

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