Inflation

What happens to a balloon when you inflate it? It gets bigger.

What happens when there is inflation in an economy? Prices get bigger.

What is Inflation?

Simply put, inflation is an increase in the price you pay for goods. So, if today you can get a small Starbucks drip coffee for the bargain price of $3, with a healthy dose of inflation in the economy that coffee could cost $6. Each dollar is worth less because you can’t buy as much with it as you used to.

What do you do?

Unfortunately, you can’t do that much. It’s possible that you could stop drinking Starbucks coffee- but the price of buying coffee beans at home will have doubled as well. So, you are not able to really avoid it.

Is there any way to benefit from Inflation?

Yes. You could borrow money. Why does this make sense?

Let’s take a scenario. Say you borrow money. You lock in a set interest rate of 4%. You invest that money in a Money Market Fund. Now, it’s important to know that Money Market Fund Interest Rates will generally move up with the Fed Funds Rate and Inflation.

After you take out your loan, inflation spikes to 6%, and your borrowed money (now in the Money Market Fund) starts to earn 6%. However, because you locked in your interest rate, you only have to pay 4% on the money. So, you are earning 6%, and paying 4% – a net gain of 2% on money that you never had in the first place!

Genius.

If You Can Benefit, You Can Also Get Hurt

Very true, Grasshopper. You can most certainly get hurt by investing in bonds during times of inflation. Why?

Let’s take a scenario. You buy a bond that earns 4% each year. Inflation is only 1% (meaning prices went up by 1% that year). So, the money you are getting from your bond (4%) minus the increase in prices (1%) means that you are ahead by 3%. Fantastic! Ok, so what happens if inflation jumps to 6%, such as in the above example? Now you are still earning 4% from your bond, but prices have increased by 6%. You’re down 2%. You would have been better off investing in a money market fund where your earning rates would move up with the Fed Funds Rate.

Read: What is a Bond?, Investing in Bonds: Part I

Related Articles: The Fed Funds Rate: To Save or Borrow?, The Rates: Fed Funds, Discount and Prime