Let’s start with an overview of the different kinds of inflation, the historical basis for past inflation, and implications on different types of investments. From my research, I hope to take those detailed topics and explain them in plain language.

There are three types of inflation: monetary inflation, consumer price inflation, and asset price inflation.

Monetary inflation involves the rapid increase in the broad money supply. This results from either an increase in bank lending, or large fiscal deficits. Whether this leads to more to asset price inflation, or consumer price inflation (or neither) depends on a few variables.

Consumer price inflation occurs when the estimated market price of a broad set of goods and services increases. This can be seen as the change in the price of identical products, like milk, today versus 10 years ago.

Asset price inflation can be characterized as investment growth – the prices and valuations of financial assets, like stocks, bonds, real estate, commodities, art, and collectibles growing over time. Assets are things that can be held for a period of time and tend to increase in price over the long term.

As interest rates rise, it puts downward pressure on most asset prices, as we saw in the inflationary decade of the 1970s. When interest rates remain low, then monetary inflation remains a decent environment for asset prices.

How does all of this impact my investment portfolio?

In terms of investing, there is no guaranteed rule since each inflationary, or deflationary, period has different reasons for occurring, but there are some consistencies.

Different asset classes respond much differently in periods of high or low inflation. Unsurprisingly, bonds and other fixed cash flow streams are harmed by inflation, which eats away at the real return (inflation-adjusted rate of return) of that cash flow. However, decades of disinflation have also brought yields to very low levels, to the point that forward looking returns in bonds are very modest.

During periods of moderate to high inflation, gold and commodities tend to do extremely well. Equities outperform bonds more often than not, but it depends on the type of equities and their starting valuations. Real estate does well, mainly because leverage attached to it gets melted away from inflation. Bonds do poorly in inflationary environments.

Going forward, I believe that with the combination of sizeable broad money supply growth, along with public opinion pushing the pendulum away from globalization, inflation is certainly gaining momentum and is likely to be much higher this decade than the last…

Brad