Is inflation actually beneficial? Learn how to find investment opportunities amid rising prices.

The True Face of Inflation

In recent years, soaring prices and persistent high inflation have become global challenges, prompting many central banks, including Taiwan’s, to raise interest rates multiple times. But before discussing how inflation harms the economy, we first need to understand what inflation actually is.

Inflation, abbreviated as “inflation,” refers to a period during which prices continuously rise, leading to a decline in the purchasing power of money. Simply put, the same amount of money buys fewer and fewer goods. The most common indicator used to measure inflation is the Consumer Price Index (CPI), which tracks changes in the prices of everyday goods and services.

Why Do Prices Rise? The Four Main Drivers of Inflation

The essence of inflation is that the money circulating in the economy exceeds the supply of goods, meaning too much money chases too few goods. The main causes of inflation are:

Demand-Pull Inflation

When demand for goods increases, production and prices rise accordingly, boosting corporate profits. As profits grow, companies tend to expand consumption and investment, creating a demand cycle. Although this type of inflation pushes prices up, it also stimulates economic growth and GDP expansion. Therefore, most governments welcome this moderate demand-driven inflation.

Cost-Push Inflation

Rising raw material and production costs can also lead to inflation. During the Russia-Ukraine conflict in 2022, Europe was unable to import Russian oil and natural gas, causing energy prices to skyrocket tenfold. The CPI in the Eurozone increased by over 10% year-on-year, setting a historical record. This type of inflation reduces social output and causes GDP to decline, which is the least desirable scenario for governments.

Excessive Money Supply

Unrestrained money printing by governments directly worsens inflation. In Taiwan during the 1950s, to cope with post-war deficits, banks issued大量貨幣, leading to soaring prices. At that time, 8 million Taiwanese dollars were only worth 1 US dollar.

Self-Fulfilling Inflation Expectations

If people expect future prices to rise, they will spend in advance or demand higher wages, prompting businesses to raise prices, thus entering an inflation cycle. Once inflation expectations form, they are hard to change. Therefore, central banks worldwide emphasize “fighting inflation” to stabilize expectations.

Is Moderate Inflation Actually Beneficial? The Often Overlooked Benefits of Inflation

Many people frown at the mention of inflation, but moderate inflation can actually be beneficial to economic operation.

When people anticipate future prices will rise, they are motivated to consume, increasing demand. This demand encourages businesses to invest more, leading to higher production and economic (GDP) growth. For example, in China, when inflation rose from 0 to 5% in the early 2000s, GDP growth also increased from 8% to over 10%, exemplifying this logic.

Conversely, when inflation drops below 0 into deflation, the economy can fall into trouble. Japan experienced deflation after its economic bubble burst in the 1990s, with stagnant prices leading people to save rather than spend, causing negative GDP growth. Japan then entered the “Lost Decade” of economic stagnation.

Therefore, most central banks aim to keep inflation within a reasonable range. Developed countries like the US, Europe, the UK, and Japan target inflation rates of 2%-3%, while most other countries set targets between 2%-5%.

Beyond the national economy, inflation can also benefit certain individuals, especially those carrying debt. Although inflation devalues cash holdings, borrowers effectively pay back less in real terms. For example, if someone borrowed 1 million dollars to buy a house 20 years ago, with a 3% inflation rate, that 1 million would be worth only about 550,000 after 20 years—meaning they only need to repay half. During high inflation periods, those who purchase assets with debt—such as real estate, stocks, or gold—stand to gain the most.

How Do Central Bank Rate Hikes Combat Inflation?

When inflation skyrockets, central banks raise interest rates. Higher rates reduce market liquidity, leading to a decline in inflation.

Raising interest rates makes borrowing more expensive. For example, increasing the loan interest rate from 1% to 5% means borrowing 1 million dollars would cost 10,000 dollars annually in interest versus 50,000 dollars. Higher interest rates discourage borrowing and encourage saving, weakening demand for goods. As demand decreases, prices tend to fall, helping to curb inflation.

However, rate hikes also have costs—reduced demand can lead to layoffs, rising unemployment, slower economic growth, and even potential economic crises. While raising rates can suppress inflation, it may also trigger a recession.

The Pros and Cons of Stocks During High Inflation

Low inflation benefits the stock market, while high inflation can be detrimental.

In a low inflation environment, hot money flows into stocks, pushing up prices. During periods of high inflation, governments often adopt tightening policies to control inflation, which can lead to falling stock prices.

A typical example is the US in 2022. That year, US inflation surged, with the CPI rising 9.1% year-on-year in June, hitting a 40-year high. To combat inflation, the Federal Reserve began raising interest rates from March, with a total of 7 rate hikes amounting to 425 basis points, pushing rates from 0.25% to 4.5%. The rate hikes made corporate financing difficult, putting downward pressure on stock valuations. The US stock market in 2022 had its worst performance in 14 years, with the S&P 500 down 19% and the Nasdaq down 33%.

However, investing in stocks during high inflation is not impossible. Historical data shows energy stocks perform particularly well during inflationary periods. In 2022, the US energy sector returned over 60%, with Occidental Petroleum up 111% and ExxonMobil up 74%.

Asset Allocation Strategies During Inflation

During inflationary periods, proper asset allocation becomes crucial. Investors need to find assets that can withstand inflation and generate growth, building a diversified portfolio.

Besides stocks, the following assets tend to perform well during high inflation:

Real Estate: Inflation often drives money into real estate markets, pushing property values higher.

Precious Metals (gold, silver, etc.): Gold tends to perform inversely to real interest rates; the higher the inflation, the better gold performs.

Foreign Currencies (such as USD): During inflation, central banks tend to adopt hawkish rate hikes, leading to USD appreciation.

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

A balanced approach is to allocate funds equally: 33% to stocks, 33% to gold, and 33% to USD. This combination leverages the growth potential of stocks, the hedging properties of gold, and the inflation-hedging role of the USD, while reducing risks associated with any single asset class and providing more stable returns.

Summary

Inflation is the phenomenon of rising prices leading to currency depreciation. Moderate inflation can promote economic growth, while excessive inflation damages the economy. To curb high inflation, central banks typically raise interest rates. Facing inflation threats, investors should appropriately allocate assets such as stocks, gold, and USD to prevent asset devaluation and seize investment opportunities embedded within inflation.