Inflation Defense Guide: Mastering Interest Rate Trends and Asset Allocation Secrets

The Truth Behind Soaring Prices: What Is Inflation

In recent years, prices in Taiwan have been rising steadily, and the central bank has raised interest rates multiple times in an attempt to stabilize the situation. However, many people still have only a superficial understanding of the nature of inflation.

Simply put, inflation refers to the continuous increase in the prices of goods over a period, and the opposite is the diminishing purchasing power of your money—that’s what we often call “money devaluation.” The most common indicator used to measure inflation is the CPI (Consumer Price Index), which directly reflects changes in the cost of living for the public.

Where Does Inflation Come From: Four Major Drivers

To understand investment opportunities related to inflation, you must first understand its causes. In brief, inflation results from the total amount of money in circulation exceeding the actual output of the economy. Too much money chasing limited goods leads to soaring prices.

Demand-driven is the primary factor. When consumer demand increases, production of goods rises, corporate profits grow, and this further stimulates consumption, creating a positive feedback loop. Although this demand-pull inflation pushes prices higher, it also leads to GDP growth, which most governments welcome.

Cost pressures are the second major driver. Rising prices of raw materials, energy, and other production factors directly translate into higher prices for end products. During the Russia-Ukraine conflict in 2022, Europe’s energy supply was disrupted, causing oil and gas prices to surge more than tenfold. The Eurozone’s CPI annual increase exceeded 10%, reaching a historic high. Cost-push inflation like this, coupled with declining economic output, is the least desirable scenario for central banks.

Money supply excess has historically caused hyperinflation. After World War II in Taiwan during the 1950s, large deficits led the central bank to print大量钞票, resulting in runaway inflation, with 8 million legal tender notes finally only exchanging for 1 US dollar.

Inflation expectations are the fourth hidden driver. When the public anticipates that prices will continue to rise, consumer spending increases, and workers demand higher wages. Businesses also raise prices accordingly, leading to an inflation spiral. Once inflation expectations rise, it becomes very difficult to reverse quickly. Therefore, central banks worldwide strive to anchor inflation expectations.

How Rate Hikes Combat Inflation

Central bank rate hikes are a conventional tool to fight high inflation. When interest rates rise, borrowing costs increase—if a loan of 1 million used to have an annual interest of only 10,000, after rate hikes, the same amount might cost 50,000 annually. Higher borrowing costs make consumers and businesses more inclined to save rather than spend, tightening market liquidity and reducing demand for goods.

Demand contraction naturally leads to falling prices, which helps lower overall price levels. However, this is a double-edged sword—businesses may cut back on hiring, unemployment rises, economic growth slows, and a recession could be triggered. This explains why rate hikes, while controlling inflation, often come with economic pain.

Moderate Inflation Is Actually an Economic Nutrient

Many people fear inflation, but moderate inflation can be beneficial for the economy. When people expect future prices to rise, their consumption appetite is stimulated, boosting demand and encouraging businesses to invest, which increases production and expands GDP.

China’s experience in the early 2000s illustrates this: as CPI rose from 0 to 5%, GDP growth accelerated from 8% to over 10%.

Conversely, if inflation drops into negative territory, the market risks falling into deflation. Japan’s painful experience in the 1990s is a case in point—after the economic bubble burst, prices stagnated, consumers hoarded money instead of spending, and GDP contracted, leading to what is called the “Lost Thirty Years.”

This is why major central banks aim to keep inflation within a relatively moderate range: developed countries like the US, Europe, the UK, Japan, Canada, and Australia generally target 2%-3%, while most other nations aim for 2%-5%.

Additionally, inflation benefits certain groups, especially those with debt. Although inflation erodes cash value, debtors effectively pay back less in real terms. For example, a 1 million mortgage taken out 20 years ago with 3% annual inflation means that after 20 years, the real value of that debt is only about 550,000, significantly easing repayment pressure. This explains why, during high inflation periods, investors who buy assets like real estate, stocks, or gold with borrowed money often see the greatest returns.

Stock Market Performance During Inflation

Low inflation favors stocks, while high inflation is a headwind. In low inflation environments, abundant market liquidity and hot money tend to flow into equities, pushing stock prices higher. Conversely, during high inflation, central banks tend to tighten monetary policy, putting downward pressure on stock prices.

The 2022 US stock market is a typical example. US inflation continued to rise, with CPI year-over-year reaching 9.1% in June, a 40-year high. The Federal Reserve began raising interest rates in March, with a total of 7 hikes and 425 basis points increase throughout the year, pushing rates from 0.25% to 4.5%. The rising cost of financing suppressed corporate valuations, leading the S&P 500 to fall 19% for the year, with the tech-heavy Nasdaq dropping even more, by 33%.

However, this does not mean that investing in stocks during high inflation is impossible. Energy stocks often perform well during inflationary periods. In 2022, the US energy sector gained over 60%, with Occidental Petroleum up 111% and ExxonMobil up 74%, becoming some of the few sectors to outperform the market.

Investment Allocation Strategies in Inflationary Times

Facing inflation, proper asset allocation is crucial. Investors should build diversified portfolios across stocks, bonds, precious metals, real estate, and other assets to spread risk effectively.

Core assets that perform well during inflation include:

Real estate: During high inflation, the money supply expands significantly, often flowing into the real estate market and driving property appreciation.

Precious metals (gold, silver, etc.): Gold has an inverse relationship with real interest rates (real interest rate = nominal rate - inflation). The higher the inflation and the lower the real interest rate, the more attractive gold becomes.

Stocks: Short-term performance varies, but over the long term, stocks tend to outperform inflation.

Strong foreign currencies (USD, etc.): During high inflation, the Federal Reserve often adopts hawkish rate hikes, leading to significant US dollar appreciation.

A feasible allocation approach is to divide funds into three parts: 33% in stocks to capture growth, 33% in gold to preserve value, and 33% in USD to hedge against inflation. This combination leverages stock growth potential while providing protection through precious metals and a strong currency, further diversifying risks across asset classes and building a relatively resilient investment defense.

Summary: Investment Wisdom in Inflationary Times

Inflation is essentially a continuous rise in prices. Moderate inflation can stimulate economic vitality, but excessive inflation harms the economy. Central banks use tools like rate hikes to keep inflation within a reasonable range.

For investors, the key is recognizing the dual nature of inflation: it is both a risk (cash devaluation) and an opportunity (asset appreciation). By strategically allocating across stocks, gold, real estate, and the US dollar, investors can protect their purchasing power and seek growth amid inflation.