## Financial Wisdom in an Era of Rising Prices: Understanding Inflation and Asset Allocation

In recent years, global price surges have become commonplace, and Taiwan is no exception, with inflation rates remaining high. To protect your assets in such an environment, it is essential to first understand what inflation is and how this phenomenon influences our investment decisions.

## The Nature of Inflation

When the prices of goods and services continue to rise over a period, the purchasing power of money decreases accordingly. We refer to this phenomenon as inflation, abbreviated as CPI. In other words, the money in your pocket becomes increasingly less valuable.

The most common indicator used to measure this is the Consumer Price Index (CPI), which tracks changes in the prices of a basket of representative goods and services, providing an intuitive reflection of overall price level trends.

## Why Does Inflation Occur?

The fundamental cause of inflation lies in the money supply exceeding the actual supply of goods and services in the economy. Excessive money chasing insufficient goods naturally pushes prices higher. Several factors often trigger inflation:

**Demand-Pull Inflation** — When consumer demand for goods increases, businesses respond by increasing production to meet this demand, which pushes prices upward. As profits grow, businesses tend to expand investments and consumption, creating a positive feedback loop. This type of inflation is often accompanied by economic growth (GDP rising), prompting governments to stimulate demand to achieve economic expansion.

**Cost-Push Inflation** — When the costs of production factors such as raw materials and energy rise, companies are forced to raise their prices. For example, during the Russia-Ukraine conflict in 2022, Europe faced energy import disruptions, leading to soaring energy prices. The Eurozone’s CPI annual growth rate once exceeded 10%, setting a record. This type of inflation can lead to decreased output and GDP contraction, which central banks aim to avoid.

**Excessive Money Supply Expansion** — When governments excessively issue currency without restraint, inflation is inevitable. Taiwan’s experience in the mid-20th century serves as a lesson: in response to post-war deficits, banks issued large amounts of currency, causing prices to skyrocket and currency to depreciate sharply.

**Self-Fulfilling Inflation Expectations** — When the public anticipates continued price increases, their behavior changes; wages demand rises, and businesses raise prices, creating a cycle of inflation. Once such expectations form, they are difficult to reverse, prompting central banks to firmly commit to controlling inflation.

## Why Do Rate Hikes Suppress Inflation?

When inflation rates are high, central banks often respond by raising interest rates. Higher rates mean increased borrowing costs and greater incentives to save, leading to reduced liquidity in the market.

Specifically, if borrowing interest rates rise from 1% to 5%, the annual interest on a 1 million NT dollar loan jumps from 10,000 to 50,000 NT dollars. This cost increase makes borrowers more cautious, with many opting to save rather than spend. As demand weakens, businesses may lower prices to promote sales, leading to a decline in overall price levels.

However, rate hikes also have costs. When demand softens, companies may cut jobs, unemployment rises, economic growth slows, and a recession may ensue. This is why central banks must carefully balance efforts to curb inflation with the risk of over-restricting the economy.

## Why Moderate Inflation Can Be Beneficial to the Economy

Many people fear inflation, but moderate inflation can actually be beneficial for economic development.

When people expect future prices to rise, they are more willing to spend now rather than hold cash. This increased consumption encourages businesses to expand investments and production, ultimately driving economic growth. For example, China’s experience in the early 2000s shows that when CPI rose from 0% to 5%, GDP growth accelerated from 8% to over 10%.

Conversely, when inflation rates fall below zero (deflation), the economy can suffer. Japan experienced a prolonged period of deflation after the burst of its economic bubble in the 1990s. With stagnant or falling prices, consumers tend to save rather than spend, leading to negative GDP growth. Japan subsequently entered the “Lost Decade(s).”

Therefore, major central banks worldwide set inflation targets within a reasonable range. Developed countries like the US, Europe, the UK, Japan, Canada, and Australia generally aim for 2%-3%, while other nations often target 2%-5%.

## Who Benefits from Inflation?

**For debtors, inflation is actually advantageous.** Although inflation erodes cash value, for borrowers, the real amount of debt to be repaid diminishes. For example, borrowing NT$1 million at a 3% inflation rate twenty years ago to buy property means that after 20 years, the NT$1 million has depreciated to about NT$550,000, so the borrower effectively repays only half of the original amount.

This is why investors who leverage debt to purchase assets (stocks, real estate, precious metals, etc.) can achieve the greatest gains during periods of high inflation.

## How Does Rising Prices Affect the Stock Market?

**Low inflation benefits stocks, high inflation harms them.** In a low inflation environment, market funds tend to flow into stocks, pushing prices higher. However, during high inflation periods, central banks adopt tightening policies, which put downward pressure on stock prices.

The 2022 US stock market is a prime example. That year, US inflation continued to rise, with the CPI annual increase reaching 9.1% in June, a 40-year high. The Federal Reserve began raising interest rates in March, with a total of 7 rate hikes throughout the year, increasing by 425 basis points, from 0.25% to 4.5%.

The rising borrowing costs dampened corporate earnings expectations, heavily impacting stock valuations. The S&P 500 index fell 19% in 2022, and the Nasdaq, dominated by tech stocks, declined 33%, marking the worst performance in 14 years.

However, high inflation periods are not entirely bleak. **Energy-related stocks often perform well.** Historical data shows that in 2022, the US energy sector returned over 60%, with Western Oil up 111% and ExxonMobil up 74%, far outperforming the broader market.

## How to Allocate Investment Portfolios During a Price Surge

In the face of high inflation, proper asset allocation becomes crucial. Investors should build diversified portfolios to hedge against inflation risks and achieve long-term asset growth.

The following assets tend to perform well during high inflation:

**Real Estate** — During rising prices, market liquidity is abundant, and capital tends to flow into real estate, driving property appreciation.

**Precious Metals (Gold, Silver, etc.)** — Gold prices are inversely related to real interest rates (nominal interest rate minus inflation). The higher the inflation, the more attractive gold becomes.

**Stocks** — Performance may vary in the short term, but over the long term, stock returns generally outpace inflation.

**Foreign Currencies (USD, etc.)** — During high inflation, the Federal Reserve tends to raise interest rates aggressively, making the US dollar a safe haven asset.

**Energy and Related Industries** — As mentioned, energy stocks tend to perform strongly during high inflation.

A feasible asset allocation strategy is diversification, such as evenly distributing funds: 33% in stocks for growth potential, 33% in gold for preservation of value, and 33% in US dollars for inflation hedging. This combination allows investors to enjoy market growth, benefit from gold’s store-of-value properties, and hedge against inflation with the US dollar, reducing risks associated with any single asset class and providing more stable returns.

## Summary

Inflation is the phenomenon of continuous price increases and declining currency purchasing power. Moderate inflation supports economic growth, but excessive inflation can cause economic damage, which is why central banks use tools like interest rate hikes to regulate it. In such environments, investors can protect their assets from inflation erosion by diversifying across assets—including stocks, gold, US dollars, and real estate—to achieve real returns. The key is to plan ahead and act early.