Inflation can have a negatꦰive effect on fixed-income assets when it leads to higher interest rates. Centralꦏ banks like the U.S. Federal Reserve typically set inflation targets, and when inflation exceeds the desired threshold, they raise interest rates to bring it under control.

Since the interest payments from existing fixed-income assets become less competitive relative to newer, higher-rate fixed-in🍃come instruments, the prices of existing fixed-income assets in the bond market will fall. In other words, there is an inverse relationship between interest rates and fixed-income asset prices.

High inflation also undermines the returns investors get from fixed-income assets. You'll receive the same amount of cash, but it no longer buys as much as it did when you chose the investment.

What Drives Inflation

Inflation is a sustaine𒉰d increase in the price levels of goods and services thro🥂ughout an economy.

There is no unanimous consensus on the primary cause of inflation, but most economists agree that it tends to surface during periods of economic stren🍌gth. It can also appear when the price of a core commodity, such as oil or wheat, suddenly and dramatically 🌱increases because commodities are a primary component of the CPI.

When unemployment rates fall, companies are forced to raise wages because🏅 econ🤪omic circumstances inevitably lead to more job openings than available workers. This generally increases production costs. Those increases are passed along to the consumer in the form of higher prices for goods and services.

Inflation and Interest Rates

ꦉFixed-income assets are investments in the debt of a government or a company. They deliver regular payments—sometimes called coupons—to the holders of the debt until the date they reach their maturity. The initial investment🃏 is then returned.

Examples include corporate bonds, federal, state, and municipal bonds, and bank ce✅rtificates of deposit (CDs).

For instance, a company may issue a 5% corporate bond with a $1,000 face value that matures in five years. This means that the⭕ bond will pay its owner $50 (5% of $1,000) per year for five years, at which time the $1,000 will be returned to the investor.

Now, suppose that during those five years, inflation drives up interest rates. That adversely affects the investor in several waysꩵ:

• In the bond market, that company and all other bond issuers might now have to pay 6% in interest to find investors for their new bonds. The holder of the existing 5% bond will not be able to sell it at its full $1,000 face value. It might be worth around $850 (minus the amount already paid out in interest), which translates into an annual yield for its new owner of about 6%.
• The bond investor's alternative is to hold onto the bond until it reaches its maturity, collecting the 5% payments and getting back the full $1,000 face value at maturity. However, inflation has reduced the real spending power of both the interest payments and the $1,000 that is returned to the investor.
• Investors talk about "opportunity cost, " which is the "shoulda-coulda-woulda" factor. A five-year commitment to a 5% return has denied the investor the opportunity to earn a better return on that $1,000.

Time Matters

The longer the term of a bond, the greater the risk that inflation will hurt the investor's real return.

Fixed-income assets can be found w꧃ith terms ranging from a few months to five years or more. The longest bond offered by the U.S. Treas💦ury is a 30-year bond.

An investor in a one-year bond is taking less risk that inflat🧜ion will erode its value before the bond matures.

Inflationary Risk

Understanding the difference between nominal and real i🔯nterest rates illustrates how inflation harms fixed-income assets.

A bond's nominal interest rate does not take inflation into account. A fixed-rate bond is just that. If it says 5%, the investor will be paid 5%. If that translates to $50 a month, the investor will get $50 every month, whether the inflation rate is up, down, or zero percent.

But if inflation has reduced spending power, that investor's $50 is worth less in the real world. As an extreme example, consider the fact that $100 in 1900 bought as much as $3,757.20 in January 2025 when adjusted for inflation.

The real interest rate establishes the investor's actual return by subtracting inflation from the nominal interest rate. For example, if the nominal interest rate is 4% and inflation is 3%, the real interest rate is 1%.

If inflation is higher than the nominal interest rate, the bondholder's return is not keeping pace with the rising cost of living.

While many investors rely on bonds as a predictable source of income, periods of high inflation will undermine their returns. This is known as 澳洲幸运5开奖号码历史查询:inflationary risk.

CPI vs. PPI

One of the most problematic aspects of inflation is that its impact on investments is not stated explicitly. Instead, investors monitor economic indicators like the 澳洲幸运5开奖号码历史查询:Producer Price Index (PPI) and the Consumer Pr♚ice Index (CPI) to get a sense of inflation trends.

When economists talk about inflation, they are usually referring to a rise in the 澳洲幸运5开奖号码历史查询:Consumer Price Index, which tracks overall🎃 prices at the retail level.

The Producer Price Index tracks changes in the prices of consumer goods and capital goods paid to producers (mostly by retailers). That means that an inflationary trend wil🐼l show up ꦓearlier in the PPI than in the CPI.

So the PPI can be useful to inves🌃tors as an early signal of impend♑ing inflation.

The Bottom Line

Inflation affects fixed-income investments by influencing interest rates, a monetary policy favorite tool of the Federal Reserve. The Fed raises and lowers interest rates in res꧑ponse to inflation, which acts to increase or decrease the value of existing fixed-income assets. In turn, the real return you get from your fixed-income investments depends on what inflation is doing.