Understanding Inflation: From Economic Phenomenon to Investment Opportunity

What Does Inflation Mean?

When discussing the current economic situation, the term “inflation” appears frequently. Simply put, inflation means that over a period of time, prices continuously rise, and the money you hold becomes less and less valuable. This is not just simple price fluctuations but a systemic phenomenon caused by an excess of circulating currency relative to the supply of goods within the entire economy.

The most common indicator used to measure inflation is the Consumer Price Index (CPI). When CPI continues to rise, it indicates that you need to spend more money to buy the same goods, reflecting a decline in the purchasing power of money.

How Does Inflation Occur?

To truly understand what inflation means, it is essential to understand its fundamental causes. The essence of inflation is that the amount of money circulating within the economy exceeds the actual supply of goods. The main historical causes of inflation include:

Demand-Pull Inflation — When overall demand for goods in society increases, businesses ramp up production, and prices also rise. In this case, economic growth (GDP) also increases, so governments often welcome this type of inflation. For example, in early 21st-century China, CPI rose from 0 to 5%, while GDP growth rate increased from 8% to over 10% during the same period.

Cost-Push Inflation — Rising raw material costs lead to higher prices. During the Russia-Ukraine conflict in 2022, European energy prices soared tenfold, and the Eurozone CPI annual rate exceeded 10%, hitting a record high. This type of inflation can lead to decreased economic output and is a target for central banks to control.

Excess Money Supply — Unrestrained printing of money by governments directly causes inflation. Taiwan’s history provides an example: in the 1950s, to cope with post-war deficits, the Bank of Taiwan issued large amounts of currency, which caused 8 million legal tender notes to be worth only 1 US dollar at that time.

Expected Inflation Rise — When people expect future prices to continue rising, consumer demand increases, workers demand higher wages, and businesses raise prices accordingly, creating a vicious cycle. Once expectations are established, they are hard to change.

How Do Rate Hikes Suppress Inflation?

In recent years, we often hear news about central banks raising interest rates. The relationship between rate hikes and inflation is very direct: when the central bank raises interest rates, borrowing costs increase, people are less willing to take loans, and instead tend to deposit money in banks. This reduces market liquidity, decreases demand for goods, and merchants lower prices to attract consumers, causing prices to fall.

For example, if the loan interest rate rises from 1% to 5%, borrowing 1 million yuan results in annual interest increasing from 10,000 to 50,000 yuan. This cost difference prompts many consumers and businesses to reconsider whether borrowing for consumption or investment is worthwhile.

However, rate hikes come with heavy costs. When demand decreases, companies lay off workers to cut costs, unemployment rises, economic growth slows, and a recession may occur. That is why central banks must carefully balance: they need to suppress inflation while avoiding excessive economic downturn.

The Benefits of Moderate Inflation to the Economy

Many people associate inflation with negative effects, but in fact, moderate inflation is beneficial to the economy. When people expect future prices to rise, consumers accelerate spending, businesses increase investment, and output grows, leading to faster economic growth.

Conversely, when prices stagnate or even fall (deflation), people prefer to save rather than spend, causing economic stagnation. Japan experienced deflation after its economic bubble burst in the 1990s; with prices nearly unchanged, people lost the motivation to consume, GDP contracted, and ultimately entered the “Lost Decade.”

Therefore, major central banks worldwide set clear inflation targets: the US, Europe, the UK, Japan, Canada, Australia, and others aim for an inflation rate of about 2%-3%, while most other countries set targets between 2%-5%.

Who Benefits from Inflation?

Debtors benefit the most. Although inflation erodes cash value, borrowers’ real repayment amounts also decrease. For example, borrowing 1 million yuan to buy a house 20 years ago, with a 3% annual inflation rate, means that after 20 years, 1 million yuan has depreciated to about 550,000 yuan, so they only need to repay roughly half the original amount. This is why investors who leverage debt to buy stocks, real estate, gold, and other assets often profit most during high inflation periods.

The Impact of High Inflation on the Stock Market

The conclusion is simple: low inflation benefits the stock market, high inflation harms it.

In a low inflation environment, market funds flow into stocks, pushing prices higher. But during high inflation, central banks adopt tightening policies to curb prices, increasing corporate financing costs, and suppressing stock valuations.

A vivid example is the United States in 2022. In June, CPI hit 9.1%, a 40-year high. The Federal Reserve began raising interest rates in March, with a total of 7 hikes amounting to 425 basis points throughout the year, pushing rates from 0.25% to 4.5%. As a result, the S&P 500 fell by 19%, and the tech-heavy NASDAQ dropped by 33%, marking the worst performance in 14 years.

However, this does not mean that high inflation periods are entirely unprofitable. Energy stocks often perform remarkably well during such times. In 2022, the US energy sector returned over 60%, with Western Oil up 111% and ExxonMobil up 74%. This is because rising energy prices during high inflation directly increase energy companies’ profits.

Asset Allocation Strategies During Inflation

In a high inflation environment, investors need to build diversified portfolios that include assets with different performance characteristics. The following assets tend to perform better during inflation:

Real Estate — When market liquidity is abundant, funds often flow into real estate, driving up property prices.

Precious Metals (Gold, Silver) — Gold is inversely related to real interest rates. Real interest rate = nominal interest rate – inflation rate. The higher the inflation, the lower the real interest rate, and the more valuable gold becomes.

Stocks — Short-term performance varies significantly, but long-term returns generally outpace inflation.

Foreign Currencies (e.g., US dollar) — During high inflation, central banks often adopt hawkish rate hikes, causing the US dollar to appreciate.

A simple allocation plan is to divide funds equally: 33% in stocks, 33% in gold, and 33% in US dollars. This approach allows investors to enjoy the growth potential of stocks, benefit from gold’s hedging properties, and capitalize on the US dollar’s appreciation, effectively diversifying risk.

Summary

In short, inflation means the devaluation of money and rising prices. Moderate inflation can promote economic growth, while high inflation can damage the economy. Central banks use rate hikes to curb high inflation, but this may trigger economic recession. In different inflation environments, investors should adjust their asset allocations accordingly, diversifying among stocks, gold, US dollars, and other assets to hedge against inflation risks and seek growth opportunities.