What is Inflation Risk?
Inflation Risk is a key economic concept that refers to the potential reduction in the purchasing power of money over time attributable to rising prices of goods and services in a country’s economy.
Simply put, inflation occurs when the general price level in an economy increases, causing each unit of currency, such as the US dollar (USD), to purchase fewer goods and services relative to prior periods.
In effect, individual consumers and businesses face the challenge of maintaining the state of their financials in the face of eroding monetary value.
Hence, inflation risk presents widespread implications to capital allocation, budgeting, financial planning, investment decision-making, and economic policy formulation, among others.
How Does Inflation Risk Work?
In economics, inflation risk (or purchasing power risk) describes the potential for money to lose its purchasing power over time due to rising prices of goods and services.
The catalyst for rising inflation can seldom be individually pointed out, given the sheer complexity of the economic system and number of moving pieces.
Broadly put, however, factors such as monetary policy, economic growth (or lack thereof), and supply-demand imbalances in market are the most often cited causes for rising price levels.
However, to truly comprehend and analyze inflation risk, one must recognize the underlying components of each high-level concept, including the interconnectedness of each variable.
The mechanics of inflation risk tend to operate through a chain of economic events, wherein as prices rise, each unit of a given currency can buy fewer goods and services than before.
The erosion of purchasing power can occur gradually across time, often going unnoticed in the short term but compounding to significant effects with wide-ranging implications across all sectors over longer periods.
From the perspective of individuals and businesses of all sizes, the annual inflation rate must be carefully considered in investment and capital allocation decisions, as inflation risk can have substantial ramifications on the value of long-term savings and returns on investments, like fixed income securities, that do not keep pace with inflation.
| Entity | Impact of Inflation Risk |
|---|---|
| Individuals |
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| Businesses |
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| Investors |
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The risk of inflation (and the net impact), however, does not affect all sectors of the economy uniformly, as different industries (and asset classes) are prone to experience varying rates of price increases, contributing toward disparate effects.
The aforementioned variability inserts yet another layer of complexity to mitigating inflation risk, as it requires a more nuanced understanding of economic trends and sector-specific dynamics.
How to Mitigate Inflation Risk
Given the scope at which inflation impacts the broader economy, the central government, such as the Federal Reserve System (or the Fed) in the U.S., must implement policy measures to maintain economic stability and manage inflation expectations.
In particular, central banks utilize monetary policy tools, such as interest rate adjustments, to meet target inflation rates, where the aim is to strike the right balance between supporting economic growth (GDP) without excess price increases.
For a real-life example, the U.S. Federal Reserve implemented a series of aggressive monetary policy measures to mitigate inflation risk in the post-COVID-19 economic landscape.
The Federal Reserve’s approach to fend off the risk of inflation required a multi-faceted approach:
| Monetary Policy | Description |
|---|---|
| Interest Rate Adjustments |
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| Quantitative Tightening |
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| Forward Guidance |
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| Asset Purchase Tapering |
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Collectively, the Fed’s strategies were intended to normalize demand, stabilize prices, and bring inflation back to the long-term target of 2.0%, demonstrating a comprehensive approach to inflation risk mitigation in extraordinary economic circumstances.
Fixed-income securities, such as bonds or certificates of deposit (CD), are particularly vulnerable to inflation risk as their nominal returns may not adjust to compensate for rising prices. Likewise, individuals relying on fixed income investments, such as retirees or those holding securities structured with long-term fixed-rates, are prone to suffering a loss in purchasing power over time. Furthermore, the compounding effect of inflation over many years can lead to substantial erosion of wealth if not adequately addressed.
On that note, the risk of inflation necessitates portfolio construction strategies that can potentially outpace inflation, such as diversifying into assets like stocks, real estate, or inflation-protected securities.
How to Calculate Inflation Risk
The Consumer Price Index (CPI) serves as the standard benchmark for measuring inflation. The CPI tracks changes in the prices of a representative basket of goods and services over time, providing a comprehensive measure of consumer inflation.
For instance, the annual inflation rate in the United States was 2.9% for the 12 months ending in July as of August 14, 2024, per the U.S. Labor Department.
The CPI is widely criticized by practioners for being an imperfect measure of inflation, akin to the usage of beta as a measure of risk, yet the CPI continues to be the most utilized proxy for inflation due to the absence of a more reliable model.
With that said, calculating inflation risk combines combines historical data analysis, economic forecasting, and statistical methods to estimate future inflation rates and their effects on purchasing power, as opposed to a single, straightforward formula.
A multitude of economic indicators and financial metrics must be analyzed to arrive at a comprehensive estimate of the potential erosion of value that stems from the anticipated inflationary risk.
Given the historical and projected CPI data, the basis for more complex calculations of inflation risk is formed, where the real rate of return on investments or the future purchasing power of a given amount of money can be determined.
To calculate the impact of inflation risk on investments or savings, the concept of the real rate of return is frequently used.
The real rate of return is calculated by subtracting the expected inflation rate from the nominal return of an investment to determine its real value upon adjusting for the inflation rate.
Note: There are far more sophisticated models out there, of course, that incorporate probability distributions of future inflation rates to estimate a range of possible outcomes and associated risks, but the use-case is predominately concentrated in academia.
Inflation Risk Formula
Real Rate of Return
The real rate of return represents the actual economic benefit an investor receives from an investment after accounting for the effects of inflation.
By subtracting the inflation rate from the nominal return, the real rate of return reveals whether an investment has genuinely increased in value or merely kept pace with rising prices in the economy.
Where:
- Nominal Rate ➝ The stated rate of return on an investment prior to adjusting for the inflation rate.
- Inflation Rate ➝ The implied rate of inflation at which the general level of prices for goods and services is rising.
Intuitively, the real rate of return formula adjusts the nominal return for the effects of inflation to portray the actual increase in purchasing power.
Thereby, the real rate of return, or “Inflation-Adjusted Return”, offers a more accurate measure of an investment’s performance by adjusting the nominal return for changes in purchasing power over time.
The real rate of return allows investors to assess the true value of their investments in terms of goods and services that can be purchased, rather than merely focusing on the nominal monetary increase.
Break-Even Inflation Rate Formula
In the bond markets, the break-even inflation rate is used to gauge market expectations of future inflation. This rate is calculated as the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.
Where:
- Nominal Bond Yield ➝ The yield on a standard government issued bond.
- Inflation-Protected Bond Yield ➝ The yield on an inflation-linked bond with a comparable maturity.
The break-even inflation rate estimates market expectations of future inflation by comparing yields on nominal and inflation-protected bonds.
Fisher Equation Formula
The Fisher Equation, named after economist Irving Fisher, establishes the relationship between nominal interest rates, real interest rates, and expected inflation. The equation provides a framework for understanding how inflation expectations influence nominal interest rates in an economy.
The Fisher Equation demonstrates that the nominal interest rate can be decomposed into two components: the real interest rate and the expected inflation rate.
The formula that underpins the Fisher Equation is as follows:
Where:
- Nominal Interest Rate ➝ The observed interest rate in the market, not adjusted for inflation.
- Real Interest Rate ➝ The interest rate that has been adjusted to remove the effects of inflation.
- Expected Inflation Rate ➝ The rate at which the general level of prices for goods and services is anticipated to rise in the future.
The Fisher Equation connects nominal interest rates to real interest rates and expected inflation, illustrating how inflation expectations influence nominal rates.
Inflation Risk Premium Formula
The inflation risk premium reflects the incremental return investors require for bearing the risk of unexpected inflation. The size of the premium is contingent on the uncertainty around the deviation between the expected and actual inflation, potentially eroding the real value of fixed nominal payments.
The formula to calculate the inflation risk premium subtracts the real yield and expected inflation from the nominal yield of a bond.
Where:
- Nominal Yield ➝ The stated yield on a nominal bond.
- Real Yield ➝ The yield on an inflation-protected bond of the same maturity.
- Expected Inflation ➝ The market’s expectation of future inflation.
The inflation risk premium rises and declines in tandem with the current economic conditions, policy expectations, and market sentiment, with higher inflation risk coincidng with higher nominal bond yields (and vice versa).
Inflation Risk Calculation Example
Suppose we’re tasked with calculating the real rate of return, break-even inflation rate, Fisher Equation, and inflation risk premium given the folllowing set of assumptions:
- Nominal Interest Rate = 5%
- Expected Inflation Rate = 2%
- Actual Inflation Rate = 2.5%
- Nominal Bond Yield = 4.5%
- Inflation-Protected Bond Yield = 1.5%
The real rate of return is calculated by dividing 1.05 (1 + 5% nominal rate) by 1.025 (1 + 2.5% actual inflation rate) and subtracting 1, resulting in approximately 2.44%.
The calculation adjusts the 5% nominal rate for the 2.5% actual inflation, reflecting the true 2.44% increase in purchasing power from the investment.
- Real Rate of Return = (1 + 5.0%) / (1 + 2.5%) – 1 ≈ 2.44%
The break-even real rate of return represents the real return an investor would receive if the expected inflation rate materializes. The calculation uses the nominal interest rate of 5% and the expected inflation rate of 2%.
- Break-Even Real Rate of Return = (1 + 5.0%) ÷ (1 + 2.0%) – 1 ≈ 2.94%
The logic here is that if the inflation rate comes in at the expected rate of 2%, the investor would earn a real return of 2.94% on their investment.
The Fisher Equation is applied using the given nominal interest rate of 5% and expected inflation rate of 2%.
Upon inserting those values into the equation and solving for the real interest rate, the yield we arrive at is approximately 2.94%.
- (1 + 0.05) = (1 + Real Interest Rate) × (1 + 0.02) ≈ 2.94%
The output aligns with the break-even real rate of return calculated in the prior step, confirming the relationship between nominal rates, real rates, and expected inflation.
The Fisher Equation demonstrates that for a 5.0% nominal interest rate and 2.0% expected inflation, investors anticipate a real return of 2.94% on their investment.
The Fisher Equation can be rearranged to solve for the real interest rate, which comes out to 2.94%.
- Real Interest Rate = (1 + 0.05) ÷ (1 + 0.02) – 1 = 2.94%
The resulting figure, 2.94%, matches the break-even real rate of return, demonstrating the relationship between nominal rates, real rates, and expected inflation.
The inflation risk premium is calculated by subtracting the inflation-protected bond yield (1.5%) and the expected inflation rate (2%) from the nominal bond yield (4.5%).
Once inserted into the formula, the inflation risk premium comes out as 1.0%. The positive value of 1% indicates that investors are demanding additional compensation for bearing the risk of unexpected inflation.
- Inflation Risk Premium = 4.5% – 1.5% – 2.0% = 1.0%
Conceptually, the inflation risk premium reflects the market’s assessment of inflation uncertainty and the extra return required to compensate for potential erosion of purchasing power.
In closing, the real rate of return of 2.44% is lower than the break-even inflation rate of 2.94% due to the higher-than-expected actual inflation, whereas the positive inflation risk premium of 1.0% implies investors in the market are demanding incremental compensation for the uncertainty of future inflation rates.
