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Understanding inflation is crucial to investing because inflation can reduce the value of investment returns. Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programs, tax policies, and interest rates.
Many commodity-based assets, such as commodity indices, can help cushion a portfolio against the impact of inflation because their total returns usually rise in an inflationary environment. However, some commodity-based investments are influenced by factors other than commodity prices. Oil stocks, for example, can fluctuate based on company-specific issues and therefore oil stock prices and oil prices are not always aligned.How can inflation be controlled? Central banks, including the U.S. Federal Reserve (the Fed), attempt to control inflation by regulating the pace of economic activity. They usually try to affect economic activity by raising and lowering short-term interest rates. Lowering short-term rates encourages banks to borrow from the Fed and from each other, effectively increasing the money supply within the economy. Banks, in turn, make more loans to businesses and consumers, which stimulates spending and overall economic activity. As economic growth picks up, inflation generally increases. Raising short-term rates has the opposite effect: it discourages borrowing, decreases the money supply, dampens economic activity and subdues inflation. Management of the money supply by the Fed, and by other central banks in their home regions, is known as monetary policy. Raising and lowering interest rates is the most common way of implementing monetary policy. However, the Fed can also tighten or relax banks’ reserve requirements. Banks must hold a percentage of their deposits with the Fed or as cash on hand. Raising the reserve requirements restricts banks’ lending capacity, thus slowing economic activity, while easing reserve requirements generally stimulates economic activity. The Fed is often credited with engineering, through monetary policy, the long period of disinflation in the U.S. that helped lead to the stock market gains of the 1990s. Starting in 1979, then-Fed Chairman Paul Volcker allowed short-term interest rates to rise continuously to break an inflationary spiral that had driven the CPI to almost 15%. In the following years, the Fed responded to economic conditions with great care, causing rates to rise and fall as needed, and brought inflation down to less than 2% by mid-2002. The federal government at times will attempt to fight inflation through fiscal policy. Although not all economists agree on the efficacy of fiscal policy, the government can attempt to fight inflation by raising taxes or reducing spending, thereby putting a damper on economic activity; conversely, it can combat deflation with tax cuts and increased spending designed to stimulate economic activity.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. Government. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value.
Correlation is a statistical measure of how two securities move in relation to each other. LIBOR (London Interbank Offered Rate) is the rate banks charge each other for short-term Eurodollar loans.
This material contains the opinions of manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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