What record inflation means for investors

Causes of Inflation: Price Increases and Ultra-Loose Monetary Policy

In general, “inflation” means that the price level of goods is constantly rising, but wages and salaries are rising more slowly than consumer prices. As a result, the value of money falls or purchasing power decreases.

Price increases can have various causes. For example, the scarcity of certain goods or services, which are becoming more expensive due to high demand at the same time.

Central banks' monetary policy can also cause inflation. When a central bank — as has the ECB for several years — increases an economy's money supply, it pumps additional liquidity into the market. As a result, consumers and companies can demand more goods than before, which in turn increases demand and prices for products and services.

In addition to higher demand, changes in supply can also be considered as an inflation driver. For example, higher wages and rising energy prices can make production processes or other services more expensive. In order to still operate profitably, the additional costs are passed on to customers in the form of price increases.

High inflation reinforced by corona pandemic

Due to the corona pandemic, there are decisive factors that promote high inflation rates. Month-long, recurring lockdowns and quarantine regulations around the world are causing production stops and supply bottlenecks. The resulting supply shortage is driving up prices and weighing on the economy.

Pour water on the mills as well rising energy and raw material costs, which both consumers and companies feel. Gas, oil or electricity are due, among other things, to the new Federal Government CO₂ taxes There has been a sharp rise in price. Last year, the CO₂ amount was 25 euros per ton of carbon dioxide emissions; since this year, 30 euros have been due and the climate tax is expected to rise to 55 euros per ton of CO₂ by 2025.

The temporarily adjusted value added tax in Germany is also considered to be a driver of inflation: In order to boost consumption during the corona crisis, the federal government temporarily reduced the value added tax to 16 and five percent, respectively, in the second half of 2020. Since January 1, 2021, Germany has had the “old” VAT rates again, which is why goods and services tended to become more expensive.

Expected economic recovery is shifting

Some market observers are already warning that that inflation is here to stay. The only question is how long. So far, for example, the European Central Bank (ECB) has repeatedly repeated its expectation that inflation will fall significantly soon. But Recently, the ECB acknowledged its mistake. For 2022, European monetary authorities expect an inflation rate of 3.2 percent — previously the forecast was just 1.7 percent. The central bank also expects higher figures in the coming years: 1.8 percent inflation for 2023 and 2024, after a previously forecast 1.5 percent.

The Ifo Institute expects similarly high figures for Germany. According to this, the inflation rate is likely to rise from 3.1 percent in 2021 to 3.3 percent in 2022. In the long term, market observers assume that the times of extremely low inflation of well under two percent are a thing of the past. For example, because energy prices are likely to continue to rise in the coming years and leading central banks will not yet completely abandon the policy of cheap money.

The role of central banks — subdued rethinking

Since the 2008/2009 financial crisis, central banks such as the US Federal Reserve Fed or the ECB have kept interest rates very low or at zero percent in order to support the economy. The consequences of the corona pandemic made even more far-reaching monetary policy measures necessary: bond purchase programs worth billions of dollars. These help states and companies alike, as they do not have to offer as high interest rates for securities when a central bank acts as a major buyer on the market.

As part of the 2015 expanded Bond buying program APP and the PEPP pandemic purchase program, the ECB has so far invested more than three trillion euros in government bonds and corporate securities. In December 2021, the central bank did decide to reduce bond purchases. But the ECB is sticking to the zero interest rate policy until further notice, which is why criticism of the monetary policy of monetary authorities is growing. The ECB is accused of underestimating the inflation risk. Business associations even see confidence in the euro at risk.

In fact, the central role of the ECB is to ensure price stability. However, if the inflation target of 2% is exceeded this year, the ECB would have to take countermeasures and raise key interest rates earlier than previously intended. As key interest rates rise, central banks dampen inflation because higher interest rates curb demand. And when less is bought, price pressure falls. Nevertheless, there is no sign of an interest rate turnaround in Europe in 2022 and, according to ECB President Christine Lagarde Very unlikely under the current circumstances.

How investors should react to inflation

For investors who have interest-bearing assets or account balances, the combination of low nominal interest rates and high inflation means a creeping capital outflow. A positive return — i.e. an increase in value after deducting the price increase — is not realizable for savers under current conditions.

On the other hand, equities are suitable for long-term asset maintenance and asset accumulation private equity or alternative asset classes. In the case of equities, the flood of money from many central banks over many years has led to enormous inflows of capital, new market participants and thus significantly rising valuations. With a long investment horizon and a diversified portfolio allocation that mitigates risks, company shares make sense to invest.

Private equity, on the other hand, invests in unlisted companies and continues to develop them operationally and strategically. Private investors are also increasingly benefiting from potential capital gains, as entry barriers and minimum deposit amounts are falling.

Other alternative investments, such as digitized tangible assets, benefit from the low correlation to traditional asset classes and will therefore continue to gain in importance as inflation protection in the future.