What is Inflation?
Inflation measures how much prices increase over time. At 3% annual inflation, something costing $100 today will cost $134 in 10 years and $181 in 20 years. Central banks typically target 2% inflation as a healthy rate for economic growth. The US Consumer Price Index (CPI) is the most widely used inflation measure.
Impact on Investments
Inflation is the silent enemy of savers. A savings account earning 1% while inflation runs at 3% means you lose 2% of purchasing power annually. Stocks have historically returned 7-10% annually, well above inflation. Bonds, real estate, and commodities like gold also serve as inflation hedges to varying degrees.
Key Considerations
Always think in real (inflation-adjusted) terms. A 6% nominal return with 3% inflation is only a 3% real return. High inflation periods like the 1970s devastated bond portfolios but benefited commodity investors. Diversifying across asset classes provides the best protection against unexpected inflation spikes.