Inflation explained in simple terms

Inflation – what does it mean exactly? Price fluctuations for goods and services are normal. When the general price level rises constantly, however, we call this inflation. This means that products become more expensive or we can afford less with the same salary. We notice this in the cost of food and electricity in particular. This can happen because raw materials or labour, among other things, become more expensive. If the cost of oil rises, for example, so will the prices of products made from oil. This leads to a decline in purchasing power.

What causes inflation?

Various factors can cause inflation. The main trigger is usually a country’s monetary policy. If the central bank pursues a loose monetary policy and provides the banks with more money accordingly (for example, in the form of favourable loans), the amount of available money increases. This usually causes consumer demand for various products to grow – causing their prices to rise. Companies can also contribute to inflation by raising prices to maximize profits or passing on increased costs (e.g. for raw materials) to consumers. Rising prices usually result in rising wages, further fuelling inflation.

How is inflation measured?

Inflation is calculated based on a shopping basket containing everyday items. The calculation can be made for all countries and is comparable. In Switzerland, the basket of goods is defined by the Swiss Federal Statistical Office (SFSO). The SFSO uses this to compile the The link will open in a new window national consumer price index on a monthly basis. The survey is based on around 100,000 prices in around 8,000 sales outlets. At 0.5 percent to 1 percent on average over the past 30 years, Switzerland has a moderate rate of inflation. Like the European Central Bank, the Swiss National Bank (SNB) has a target inflation rate of 2 percent. Since the beginning of last year, however, the inflation rate has also risen sharply in Switzerland, reaching a high of 3.5 percent in August. Only once in the past 30 years has the rate been higher. Inflation rates above 5 percent are considered high – countries neighbouring Switzerland such as Germany, France and Italy are currently experiencing these. Very high inflation where the amount of money in circulation increases sharply and the rate of inflation climbs by 50 percent per month tends to be rare. It is an indicator of crisis in the countries concerned. Such examples of hyperinflation, where banknotes are printed in absurdly high quantities, occur most frequently in developing countries.

The key rate – an important means of regulating inflation

The key rate is closely related to inflation. In Switzerland this is set by the Swiss National Bank to control inflation. The key rate is the rate at which banks can borrow money from the SNB. The banks in turn pass this onto businesses in the form of debt interest. When key rates are low, loans are less expensive for businesses and consumers. This makes investment more lucrative, generating economic growth. Consumers also spend more money due to low interest rates on loans. This causes the economy to grow and inflation to rise. However, this annoys savers because they receive a low return on their savings.

Savers are pleased when the key rate is high as they obtain more interest on their savings accounts. In contrast, borrowers and consumers take out fewer loans or spend less money. The economy slows down because people generally spend less.

The next time you hear or read that the SNB or US Federal Reserve have lowered or increased key rates, you’ll know what’s going on: a higher or lower amount of money is flowing into the economy. Central banks obviously don’t just adjust key rates due to inflation.

Why inflation is also important to your investment

Every change to key rates or the rate of inflation has implications for the financial market. For example, the stock market benefits from moderate inflation up to 4 percent. It signifies a growing economy with eager consumers. However, if inflation rises too sharply, this causes uncertainty. It can indicate that the monetary policy of major countries is too lax. This can in turn point to an economic crisis or structural problems.

In contrast to shares, changes to key rates have a major impact on bonds. If you have purchased a bond bearing low interest, it loses value as soon as new bonds offering higher interest come onto the market. This means choosing the right time to invest in bonds is vitally important. If inflation is moderate, many investors prefer to put their money into shares rather than bonds.

Tangible assets as a means of inflation protection

When inflation rates are high, many investors rely on things with real-world value, which we call tangible assets. These include real estate, but also commodities such as gold. This is mainly due to psychological factors: tangible assets – such as precious metals – give investors a greater sense of security than shares, bonds or funds in times of economic crisis or stock market corrections. Gold is usually only a suitable means of protection against inflation if the rate of inflation stands at over 5 percent – or if hyperinflation prevails. More on this can be found in the article entitled “How can I invest in commodities?”

Is investing only worthwhile when inflation is low?

In times when low rates of interest are paid on savings accounts, investors have better chances of benefiting rather than savers. Savers often only just manage to offset inflation on their savings with interest income. Meanwhile, investors have the opportunity to benefit with targeted investments, even in a low-interest environment. When interest rates rise, savings become attractive again as interest income increases for money in the bank. However, savers should always take inflation into account to assess how much they actually benefit from higher interest rates on their savings account. But investors also have the opportunity – especially with a long investment horizon – to develop their assets further in a high interest rate environment through yield-optimized investments. To increase the value of investments, it is important to take into account the personal investment strategy and, in the event of inflation, to ensure that investments are made in sectors and companies that can also effectively charge higher prices. Price rises alone are little help. For companies and/or sectors not only to be able to pay their debts despite increased interest rates, but also to benefit, they must adapt to the changed economic conditions. For example, this could be done by converting production to use different energy sources and raw materials or by increasing efficiency.