Inflation Risk

Inflation risk, also called purchasing-power risk, is the risk that rising prices will reduce the real value of money, investment returns or future payments. A saver who earns 3% while prices rise 4% is worse off in real terms even though the account balance went up. The risk falls hardest on holders of cash, fixed-rate bonds, fixed pensions and other assets whose payments are set in nominal amounts.

Inflation risk is one of the main forms of market risk and is closely linked to interest rate risk, because markets and central banks usually respond to higher inflation with higher interest rates. It matters most when inflation is high or unexpected. Lenders, savers and anyone receiving fixed payments bear it; borrowers with fixed-rate debt can benefit from it, since they repay in money that buys less.

Imagine putting a full shopping basket's worth of money in a drawer today. Ten years later you take it out to buy the same basket, but the prices on the shelf have crept up, and the money now only fills part of the basket. Nothing was stolen, yet some of the value quietly disappeared. That slow leak is inflation risk.

The leak is hard to notice because the number on the notes or the bank statement does not change. It shows up only when you compare what the money buys now with what it bought before. Over a few months the difference is small. Over a retirement lasting twenty or thirty years, it can halve what a fixed income buys.

The key figure is the real return, the return after inflation. The exact relationship, known as the Fisher equation, is:

• $r$ is the real rate of return.
• $i$ is the nominal interest rate or return.
• $\pi$ is the inflation rate over the same period.

For small rates, $r \approx i - \pi$. Take a deposit paying 5% when inflation is 3%: $1.05 \div 1.03 = 1.0194$, a real return of about 1.94%. If inflation instead turns out to be 7%, $1.05 \div 1.07 = 0.9813$, and the saver loses about 1.9% of purchasing power despite earning interest. The difference between expected and actual inflation is the risk. Inflation is usually measured with a price index such as the Consumer Price Index (CPI), and results stated after inflation are said to be in real terms. The Rule of 72 gives a quick sense of scale: at 3% inflation, prices double in about 24 years.

Exposure depends on how fixed the cash flows are:

• Cash and deposits. Money in a current account, savings account or money market account is safe in nominal terms, but its rate often lags inflation when prices rise quickly.
• Fixed-rate bonds. A fixed-income security pays set coupons and principal. Higher inflation erodes their value, and long-dated bonds are hit hardest because more payments lie further in the future.
• Fixed pensions and annuities. Retirees on payments that are not indexed lose purchasing power every year. State pensions are often protected; US Social Security, for example, applies an annual cost-of-living adjustment.
• Long-term savers. Pension funds and insurers with liabilities linked to wages or prices must earn returns above inflation to meet them.

Shares, property and commodities have historically offered some protection over long periods because companies can raise prices and real assets tend to reprice, but the link is loose in the short run. Stagflation, with high inflation and weak growth, has been especially hard on both bonds and shares.

Investors and institutions use several tools:

• Inflation-linked bonds. US Treasury Inflation-Protected Securities (TIPS) adjust their principal with the CPI, and Series I savings bonds pay a rate that combines a fixed part with an inflation part. The UK has issued index-linked gilts since 1981, and many other governments issue similar bonds.
• Shorter maturities and floating rates. Short-term bills and floating-rate notes reset quickly when rates rise, limiting how long a saver is locked into an old rate.
• Real assets. Some investors hold property, commodities or gold, accepting their own price swings in exchange for a possible hedge.
• Equities and diversification. A mix of assets with different responses to inflation reduces reliance on any single hedge.
• Indexed contracts. Wages, rents and pensions can be written with clauses that adjust payments to a price index.

Central banks try to keep inflation low and predictable, which reduces inflation risk for everyone. Many follow inflation targeting: the Federal Reserve aims for 2% inflation over the longer run, measured by the personal consumption expenditures price index, and the European Central Bank and the Bank of England also target 2%. When targets are credible, long-term interest rates carry a smaller inflation risk premium.

When credibility breaks down, inflation risk can become extreme. Episodes of hyperinflation, from Weimar Germany to Zimbabwe, wiped out savings held in local currency. Even in advanced economies, the surge after the pandemic, with US CPI inflation peaking at 9.1% over the year to June 2022, showed how quickly real returns on cash and bonds can turn sharply negative.

• TreasuryDirect: Treasury Inflation-Protected Securities (TIPS)
• Federal Reserve: Why does the Federal Reserve aim for inflation of 2 percent over the longer run?