The Economic Truth in the Era of Inflation: From Price Surges to Wealth Shrinkage, How Should Ordinary People Respond

In recent years, the global economy has faced unprecedented challenges, with prices continuously rising, central banks frequently adjusting interest rates, and investment markets experiencing increased volatility. What is the root cause behind all these phenomena? In the face of inflation, people of different identities will encounter vastly different situations. This article will help you gain an in-depth understanding of inflation and find strategies to cope with it.

The Economic Logic Behind Price Increases

When we talk about inflation, it essentially refers to the sustained rise in market prices over a period of time. This is not just a numbers game; it directly affects the purchasing power of our cash. In simple terms, inflation means your money is becoming less and less valuable.

The most commonly used indicator to measure this phenomenon is the Consumer Price Index (CPI), which accurately reflects the trend of changes in the prices of a basket of goods and services.

Why Does Inflation Occur? Four Key Factors in the Economic Cycle

The formation of inflation is not accidental but the result of multiple forces acting together within the economic system.

Demand-Pull Inflation

When market demand for goods and services increases rapidly, businesses will increase production to meet the demand. During this process, prices rise accordingly, and corporate profits also grow. As profits increase, businesses and employees will spend more, further boosting demand, creating a virtuous cycle. This demand-driven inflation is called demand-pull inflation. Although rising prices are concerning, they are usually accompanied by growth in Gross Domestic Product (GDP), which is also something governments are pleased to see.

Cost-Push Inflation

Another type of inflation results from rising production costs. When the prices of raw materials, energy, and other production factors soar, business costs increase, pushing up the prices of goods. During the 2022 Russia-Ukraine conflict, Europe’s energy supply was disrupted, and oil and natural gas prices skyrocketed tenfold, leading to an inflation rate in the Eurozone CPI of over 10%, setting a record high. The danger of this cost-push inflation is that it can lead to a decline in economic output, with GDP shrinking, which is precisely what governments aim to avoid.

Excessive Money Supply

If the government increases the money supply without restraint, the amount of circulating money in the market will increase, while the actual quantity of goods remains unchanged, inevitably leading to rising prices. Historically, hyperinflation often originates from this. In the 1950s, Taiwan responded to large deficits by printing大量鈔票, eventually 8 million法幣 could only exchange for 1 dollar, with prices soaring to unimaginable levels.

Self-Fulfilling Expectations

When people expect future prices to continue rising, consumers will buy in advance, workers will demand higher wages, and businesses will raise prices early. As a result, inflation expectations become reality, and once formed, it is very difficult to break. Therefore, central banks around the world strive to control and guide inflation expectations.

Why Raising Interest Rates Has Become the Standard Tool to Fight Inflation

In the face of soaring inflation, central banks worldwide have adopted interest rate hikes. What is the relationship between rate hikes and inflation?

The logic of rate hikes is straightforward: when the central bank raises interest rates, borrowing costs increase. Suppose the original loan interest rate was 1%, and borrowing 1 million yuan costs 10,000 yuan annually; after raising the rate to 5%, the same loan now costs 50,000 yuan annually. The high interest costs discourage borrowing, prompting people to deposit more money in banks. Market liquidity decreases, demand for goods and services drops, and businesses are forced to lower prices to stimulate sales, ultimately leading to a decline in overall price levels and controlling inflation.

However, the cost of rate hikes cannot be ignored. When demand shrinks, companies no longer need as many employees for production and sales, leading to rising unemployment. Economic growth slows down, and in severe cases, it can trigger a recession. This is the dilemma central banks face between raising rates and economic growth.

The Hidden Benefits of Moderate Inflation and the Dangers of Deflation

When mentioning inflation, people often react with fear. But in reality, moderate inflation has positive effects on economic development.

When people expect goods to be more expensive in the future, their motivation to consume increases. Rising demand encourages businesses to invest and expand production, leading to economic growth. For example, in early 2000s China, when CPI rose from 0 to 5%, GDP growth also jumped from 8% to over 10%.

A cautionary lesson comes from Japan. After the economic bubble burst in the 1990s, Japan fell into a quagmire of deflation. Prices stagnated, and people preferred saving over spending, resulting in negative GDP growth, and the country’s economy entered a period known as the “Lost Thirty Years.”

For this reason, major central banks worldwide prioritize maintaining moderate inflation. Developed countries like the US, Europe, the UK, Japan, Canada, and Australia set their target inflation rates at 2%-3%, while most other countries aim for 2%-5%.

Who Benefits from Deflation? Winners and Losers in the Inflation Era

Inflation and deflation have opposite effects on different groups. During deflation, cash holders benefit from increased purchasing power; during high inflation, those with debt are actually beneficiaries.

This may seem contradictory, but the logic is clear: inflation devalues cash, but it benefits borrowers. For example, borrowing 1 million yuan to buy a house with 3% inflation rate 20 years ago, after 20 years, the debt effectively shrinks to about 550,000 yuan, and the borrower only needs to repay roughly half of its real value.

During high inflation, those who leverage debt to acquire assets benefit the most. These assets include real estate, stocks, gold, and others. In other words, asset holders can preserve or even increase their wealth during inflation.

How Inflation Impacts the Stock Market

The relationship between inflation and the stock market is not linear. In low inflation environments, hot money flows into the stock market, pushing up stock prices; in high inflation environments, governments implement tightening policies, often putting downward pressure on stock prices.

The US stock market in 2022 provides a textbook example of the opposite. That year, inflation soared, with CPI rising 9.1% year-over-year in June, hitting a 40-year high. To curb inflation, the Federal Reserve began raising interest rates from March, with a total of 7 rate hikes amounting to 425 basis points throughout the year, pushing rates from 0.25% to 4.5%.

Rising interest rates increase corporate financing costs and also lower stock valuation multiples. As a result, the US stock market experienced its worst performance in 14 years, with the S&P 500 down 19%, and the Nasdaq, dominated by tech stocks, plummeting 33%.

Investment Opportunities During High Inflation

High inflation periods are not entirely devoid of opportunities. Historical data shows that energy sector stocks tend to perform well during such times. In 2022, the US energy sector returned over 60%, with oil-related companies experiencing particularly remarkable gains.

Additionally, investment categories that tend to be relatively resilient during inflation include:

Real Estate: In an inflationary environment, abundant market liquidity drives capital into real estate, pushing up property values.

Precious Metals: Gold has an inverse relationship with real interest rates (nominal interest rate minus inflation rate). The higher the inflation, the lower the real interest rate, making gold more attractive. Silver and other precious metals share similar characteristics.

Stocks: Although short-term performance varies, in the long run, stock returns often outperform inflation.

Foreign Currencies: During high inflation, the Federal Reserve typically adopts a more hawkish stance, leading to an appreciation of the US dollar.

Building an Inflation-Resistant Asset Portfolio

The ideal strategy is diversified asset allocation. Investors can distribute their funds across stocks, gold, US dollars, and other asset classes, for example, each constituting one-third of the portfolio. Such a mix can leverage the growth potential of stocks, benefit from gold’s preservation qualities, and hedge against inflation through the appreciation of the US dollar. This diversification effectively reduces risks associated with any single asset and provides more stable long-term returns.

Summary: Survival Rules in the Inflation Era

Inflation is a period of sustained price increases. Low inflation promotes economic growth, while high inflation damages the economy. Central banks use rate hikes to curb high inflation but must also bear the cost of economic slowdown.

In an inflationary era, asset allocation determines wealth destiny. Asset holders with debt benefit from inflation, while cash holders face shrinking purchasing power. By rationally allocating assets such as stocks, gold, real estate, and foreign currencies, ordinary investors can protect and even grow their wealth during inflation.