The truth behind soaring prices: How inflation affects your wallet

In recent years, prices have continued to rise, and central banks have repeatedly raised interest rates. These phenomena all point to the same economic concept—inflation. But do you truly understand what inflation is, how it occurs, and how to protect your assets in this era?

Why Are Money Values Getting Thinner? Understanding Inflation

Inflation refers to the general and sustained increase in prices over a period of time. Simply put, when the 100 yuan you hold can no longer buy the same goods as before, inflation is happening. The underlying essence is: too much money circulating in the economy, combined with relatively few goods and services available for purchase.

The most commonly used indicator to measure inflation is the Consumer Price Index (CPI). When CPI continues to rise, it indicates that the prices of everyday goods are increasing steadily.

How Does Inflation Happen? The Four Main Drivers

Demand-Pull Inflation

When consumer demand increases, production of goods expands, profits for businesses rise, and this further stimulates consumption—creating a demand cycle. Although this drives up prices, it also promotes economic (GDP) growth, so governments generally encourage demand.

Cost-Push Inflation

When raw material costs rise, the prices of goods follow suit. A typical example is during the 2022 Russia-Ukraine conflict, when Europe’s energy supply was disrupted, causing oil and gas prices to surge tenfold, leading to an inflation rate in the Eurozone CPI exceeding 10%, a record high. This type of inflation can cause economic output to decline, which most governments prefer to avoid.

Excessive Money Supply

Over-issuance of currency by governments directly causes inflation. Nearly all hyperinflation events in history stem from this. Taiwan in the 1950s is an example—faced with post-war deficits, the Taiwan Bank issued large amounts of currency, eventually causing 8 million legal tender notes to be worth only 1 US dollar.

Expectations of Inflation Spiral

Once people expect prices to keep rising, they will preemptively spend or demand higher wages, which further pushes up prices, forming an intractable inflation expectation. Central banks invest significant effort in signaling “we will control inflation” to the market.

Why Do Rate Hikes Become the Central Bank’s Weapon?

When inflation spirals out of control, central banks usually raise interest rates. Increasing rates raises borrowing costs—borrowing 1 million yuan at 1% interest versus 5% means annual interest jumps from 10,000 to 50,000. As a result, people tend to save more and borrow less for consumption, demand decreases, and prices tend to fall.

However, rate hikes come with costs. Reduced demand means companies need fewer employees, unemployment rises, economic growth slows, and a recession may occur. This is the dilemma of “fighting inflation at the expense of the economy.”

Moderate Inflation Is Actually Good

Many fear inflation, but moderate inflation is a sign of a healthy economy.

When people expect future goods to be more expensive, they are motivated to spend now, increasing demand and encouraging business investment and output growth, leading to economic expansion. For example, in China, when CPI rose from 0 to 5% in the early 2000s, GDP growth also jumped from 8% to over 10%.

Conversely, deflation with inflation rates below 0 causes economic stagnation. The lesson from Japan in the 1990s is clear—after the bubble burst, the country fell into deflation, with people preferring to save rather than spend, leading to negative GDP growth and ultimately the “Lost Thirty Years.”

Therefore, most major central banks worldwide set their target inflation around 2%-3% (some countries target 2%-5%), seeking a balance between economic growth and price stability.

Who Benefits Most in an Inflationary Era?

Those with debt benefit the most. Although inflation erodes cash value, if you are a borrower, the debt you owe effectively shrinks. For example, borrowing 1 million yuan to buy a house 20 years ago, with a 3% inflation rate, means that after 20 years, 1 million yuan is worth about 550,000 yuan, so you only need to repay roughly half. During high inflation periods, those who buy assets like real estate, stocks, or gold with borrowed money gain the most.

The Double-Edged Sword of Inflation on the Stock Market

Low inflation benefits stocks, high inflation harms them.

In periods of low inflation, hot money flows into the stock market, pushing up stock prices. During high inflation, central banks tend to tighten monetary policy, increasing corporate financing costs and lowering stock valuations.

2022 in the US is a typical example. CPI rose 9.1% year-over-year (a 40-year high), the Federal Reserve raised interest rates seven times for a total of 425 basis points, with rates soaring from 0.25% to 4.5%. As a result, the S&P 500 index fell by 19%, and the tech-heavy Nasdaq dropped 33%, its worst performance in 14 years.

However, high inflation also presents opportunities. Energy stocks are an exception. Historical data shows that energy companies perform well in high inflation environments. In 2022, the US energy sector returned over 60%, with Occidental Petroleum up 111% and ExxonMobil up 74%.

How to Protect Assets During Inflation

Proper asset allocation is key to resisting inflation. Investors should build diversified portfolios containing different asset classes.

High-performing investment options:

Real Estate — During high inflation, liquidity is abundant, and funds often flow into the property market, driving up prices.

Precious Metals (Gold, Silver) — Gold tends to move inversely with real interest rates. The higher the inflation, the lower the real interest rate (nominal rate minus inflation rate), and the better gold performs.

Stocks — Short-term performance varies, but long-term returns generally outpace inflation.

Foreign Currencies (e.g., US dollar) — During high inflation, central banks often adopt hawkish rate hikes, causing the dollar to appreciate.

A balanced approach could be to divide your funds into three equal parts, investing 33% each in stocks, gold, and dollar-related assets. This strategy leverages the strengths of each asset class while reducing risks associated with any single category, providing more stable long-term returns.

Summary

Inflation fundamentally results from an imbalance between money supply and goods supply. Moderate inflation promotes economic growth, but excessive inflation erodes purchasing power. Central banks control inflation through rate hikes, with the cost being potential economic slowdown.

In this era, understanding inflation, diversifying investments, and rational asset allocation are the three key strategies to protect wealth. Whether in real estate, precious metals, stocks, or foreign currencies, each has its value during inflation. The crucial point is to tailor your anti-inflation portfolio according to your risk tolerance and investment horizon.