What is inflation really all about? A comprehensive guide from the concept to practical application

What Does Inflation Mean?

Simply put, what is inflation? It means your money is becoming less valuable.

Specifically, inflation refers to a period during which the prices of goods and services continuously rise, and accordingly, the same amount of money can buy fewer items. We can understand it as: too much money in circulation, insufficient goods, and too much money chasing too few goods, ultimately pushing prices higher.

The most common indicator used to measure inflation is the CPI (Consumer Price Index), which reflects the speed of change in the prices of daily consumer goods.

Why Does Inflation Occur?

Inflation doesn’t happen out of thin air; there are several main drivers behind it:

Demand-Pull Inflation

When demand for goods suddenly increases, businesses will ramp up production to meet it. Increased production → higher profits for companies → companies continue hiring and expanding → employees have more money to spend → demand further increases. This creates a virtuous cycle (from an economic growth perspective). Although prices rise, the economy (GDP) is also growing, and governments usually encourage this situation.

Cost-Push Inflation

Rising raw material prices can also trigger inflation. For example, during the 2022 Russia-Ukraine conflict, Europe couldn’t import oil and natural gas from Russia, leading energy prices to double. As a result, the CPI in the Eurozone once exceeded 10% annually, hitting a record high.

This type of inflation is very dangerous because rising costs lead to decreased output and slower GDP growth, creating a stagflation scenario that no government wants to see.

Excessive Money Supply

When governments or central banks print money aggressively, market liquidity becomes excessive, naturally pushing prices higher. Most hyperinflations in history stem from this. For example, in 1950s Taiwan, to cope with post-war fiscal deficits, the Taiwan Bank issued大量货币, leading to 800 million old Taiwan dollars being worth only 1 US dollar.

Rising Inflation Expectations

This is the most difficult factor to control. When people expect prices to keep rising in the future, they will spend in advance; workers will demand higher wages; businesses will raise prices accordingly. This creates a self-fulfilling inflation cycle. Once expectations rise, the central bank needs to exert significant effort to reverse them.

Why Does Raising Interest Rates Suppress Inflation?

When inflation spirals out of control, the central bank’s usual move is to raise interest rates—specifically, the benchmark interest rate.

The logic is straightforward: interest rate increase → higher borrowing costs → people less willing to borrow → market liquidity decreases → demand for goods drops → prices naturally fall.

For example, if loan interest rates rise from 1% to 5%, borrowing 1 million dollars costs an extra 40,000 dollars annually. People will tend to deposit money in banks rather than borrow for consumption, reducing market demand and bringing prices down.

However, raising interest rates has a clear cost: companies will stop hiring extensively, unemployment rises, economic growth slows, and in severe cases, a recession may be triggered. That’s why markets often panic when central banks raise rates.

Is Inflation Really All Bad?

Not necessarily. Moderate inflation can be beneficial to the economy.

When people expect prices to rise, their consumption appetite increases—“buy now because it’s cheaper than later.” Increased demand stimulates business investment, boosts output, and energizes the economy. For example, in early 2000s China, CPI rose from 0 to 5%, and GDP growth increased from 8% to over 10%.

The opposite is deflation (falling or stagnant prices). Japan experienced this nightmare in the 1990s: after the economic bubble burst, prices hardly changed, people preferred saving over spending, and GDP growth turned negative. The entire country fell into the “Lost Decade.”

This is why major economies set their target inflation at around 2%-3%. Too low can lead to stagnation, too high erodes savings.

Who Benefits from Inflation?

Debtors. This may sound counterintuitive, but the logic is simple:

Inflation devalues your cash holdings, but if you owe money, the amount you owe also becomes less valuable. For example, if you borrowed 1 million dollars to buy a house 20 years ago, with a 3% inflation rate, the purchasing power of that 1 million today is only about 550,000 dollars, meaning you effectively paid less in real terms—saving approximately 450,000 dollars.

Therefore, during high inflation periods, those who buy assets like real estate or stocks with debt tend to benefit the most, as asset prices often rise with inflation.

How Do Stocks Perform Under High Inflation?

Simple conclusion: low inflation benefits stocks, high inflation harms stocks.

In low inflation periods, hot money flows into the stock market, pushing prices higher. But during high inflation, central banks adopt tightening policies, interest rates keep rising, and corporate financing costs increase, leading to lower stock valuations.

The 2022 US stock market is a typical example. That year, the US CPI rose 9.1% year-over-year (hitting a 40-year high in June), and the Federal Reserve raised interest rates 7 times, with the benchmark rate soaring from 0.25% to 4.5%. As a result, the S&P 500 fell 19% for the year, and the Nasdaq dropped 33%.

But this doesn’t mean there are no opportunities in high inflation. Historical data shows that energy sectors perform well during high inflation: in 2022, the US energy sector gained over 60%, with Occidental Petroleum up 111% and ExxonMobil up 74%.

How to Protect and Grow Assets During High Inflation?

In an inflationary environment, relying on a single asset class is no longer sufficient. Investors need to build diversified portfolios to hedge against devaluation risks.

Assets that perform relatively well during inflation:

• Real Estate: In liquid markets, funds tend to flow into real estate, pushing up property prices. Real estate serves both as a consumption item and a store of value.
• Precious Metals (Gold, Silver, etc.): Gold’s value tends to be inversely related to real interest rates (nominal interest rate minus inflation). The higher the inflation, the more attractive gold becomes.
• Energy Stocks: Oil and gas companies often perform well during high inflation, making them defensive investments.
• Foreign Currencies (USD, etc.): When central banks raise interest rates, the US dollar tends to appreciate, providing a hedge.

Practical advice:

Use a “three-part allocation” approach—divide your investment capital into three parts: growth assets (stocks), value-preserving assets (gold), and safe-haven assets (USD). This way, you can participate in economic growth, hedge against inflation, and reduce risk from any single asset class.

For example, allocate 33% to stock funds or index funds, 33% to precious metals, and 33% to USD or dollar-denominated assets. This combination can help maintain relatively stable returns across different economic cycles.

Summary

What does inflation mean? In one sentence—money becomes fuzzy, and goods become more expensive. Mild inflation is a catalyst for economic growth, but high inflation can trigger social problems. Central banks control inflation by raising interest rates, but the cost is slowing economic growth.

As investors, it’s crucial to recognize that holding cash alone in an inflation environment leads to losses. Building a multi-asset portfolio, and proactively investing in stocks, precious metals, real estate, and other assets with value-preserving and growth potential, is key to achieving real wealth growth during inflation.