Investments, why Inflation Must Come Down (today) and Why you Need to Know

Very high inflation, rising rates and winds of recession coming but, why should inflation go down? This question has an answer that lies in the macroeconomic basics that everyone involved in investing should know.

We have already dealt with the topic of macroeconomic bases and the various relationships between interest rates, inflation and the unemployment rate, but we should basically go deeper into this topic in order to understand how inflation is then linked to the markets, such as, for example, the bond market which is one of the favorite markets of retail investors or those involved in structuring portfolios with a strong bond component. Basically, knowing what inflation could be crucial for long-term investment choices tells us.

We will therefore briefly explain why inflation is important and above all how to link it to investment choices, whether short or long term.

The "target" inflation and its importance

Let us repeat briefly that inflation indicates the general price level and the inflation rate indicates the growth rate of prices. Inflation is a fundamental parameter in the economy as central banks constantly monitor inflation to implement monetary policy choices in order to maintain stability within the economy.

Let us dwell on the term “stability”, ie central banks want stability, healthy and stable growth and this only happens if inflation remains within a defined parameter “ inflation target”. To give an example, the ECB has the mandate of “inflation targeting”, i.e. bringing inflation towards the 2% target, a parameter that would indicate a healthy condition of the economy, a benchmark below which the central bank will adopt policies and above which it will implement others.

Basically, if inflation is at 2%, the central bank has an ideal condition to better control the economy. If inflation begins to have a negative trend and falls well below the target, the central bank will try to implement expansionary monetary policies, i.e. it will inject liquidity into the market, while if inflation begins to have a positive trend and goes beyond 2%, the central bank will have to implement restrictive monetary policies and which discourage the supply of liquidity on the market. Well, having done a recap of these concepts, let’s see how interest rates and inflation relate to the bond market and beyond.

Inflation and Bonds

The annual inflation rate is also a fundamental parameter in evaluating the real return of an investment. To give a very simple example, if we want to calculate the real return at the end of a year of an investment, we just need to take the return on our investment and subtract the inflation rate. If our return was 3% and inflation is at 2%, the real return will be 3%-2%, therefore 1% return.

In the current situation, taking the European market as a reference, we have inflation at 8.5%, well above the 2% inflation target set by the ECB. It follows that at the moment, an investment that must have a positive real return must yield at least more than 8.5%. At the moment, on the bond market we don’t have yields of this kind except on the stock market, while on the bond market we find yields approaching 4.5% on ten-year maturities.

For example, the latest bonds issued by the Italian government on various maturities have annual yields close to 3-4%, far from current inflation. So what to do to understand how these yields could move? Seeing the estimates of official bodies such as the European Commission regarding inflation could be an excellent idea and we see that by the end of 2023 inflation should settle at 6,1%.

In essence bond yields are still a long way from these inflation rates and therefore are relatively inconvenient, at least in theory. In this sense, we could explain why at the moment the stock markets have seen a strong increase even if there are glimmers of a strong economic slowdown. This is one of the reasons why inflation must go down, because it goes to erode real yields and therefore it is necessary that it goes down so that the States that refinance themselves through bond issues can raise money more easily by avoiding shock from the point of view of the yields offered.

How to use inflation for investing?

Let’s complicate things a little. Let’s take for example a 10-year government bond yielding 4% a year for 10 years. Is it worth having such an instrument in your portfolio? Let us assume that this inflation situation, i.e. considering the estimates for 2023 which see inflation at 6.1% and a return towards 2% for 2024, we can say that only for this year will we have a situation in which the rate of inflation could be higher than our gross stock yield.

For the first year we would lose about 2% against a 4% gross return and then start to have a positive net return for the other 9 years. Attention, this does not mean that it is better to buy bonds at 4%, also because inflation is only an evaluation parameter that could be subject to changes in the long term, therefore it could be very valid but not the only parameter judgment of the goodness of investment choices.

Another parameter is the interest rate but we will see this in the next article regarding interest rates and investment choices, given that the interest rate is closely linked to the inflation rate. In essence, start linking these basic concepts of macroeconomics to investment choices, it could be a good idea both to increase one’s financial culture and to adopt investment choices in a more informed manner, totally avoiding running into choices of "impetus" derived from the attraction of what appears to be a good return.

Original article published on Money.it Italy 2023-02-16 08:57:00. Original title: Investimenti, perché l’inflazione deve scendere (oggi) e perché devi saperlo