Inflation is the sustained rise in the general price level of goods and services within an economy. It is typically measured by the Consumer Price Index (CPI) — a basket of commonly purchased items — and expressed as a year-over-year percentage. At 3% annual inflation, $1,000 in purchasing power today becomes equivalent to roughly $744 in real terms after 10 years. Cash under the mattress is a guaranteed losing trade.
For investors, inflation has asymmetric effects depending on asset class. Equities can be an effective long-run inflation hedge because companies often pass rising input costs to consumers, growing revenues and earnings in nominal terms. Real assets — commodity producers, energy companies, farmland, infrastructure — are the most direct inflation beneficiaries. Fixed-rate bonds are the biggest inflation losers: a bond paying 3% when inflation rises to 7% is generating a -4% real yield, destroying purchasing power with every coupon payment.
The most dangerous inflation regime is stagflation — a toxic combination of high inflation, stagnating economic growth, and rising unemployment. This virtually eliminates the central bank's traditional toolkit: cutting rates would worsen inflation, while raising rates deepens the recession. The 1970s U.S. stagflation saw the S&P 500 deliver a negative real return for nearly a decade after accounting for inflation, devastating retirees and conventional 60/40 investors.
Central banks manage inflation primarily through interest rate policy. When inflation runs hot, central banks raise the benchmark interest rate (e.g., the Federal Funds Rate in the U.S.), making borrowing more expensive, cooling consumer spending, and suppressing demand. The 2022 Fed rate hiking cycle — the fastest since Paul Volcker in the early 1980s — raised rates from 0% to over 5% in 18 months, triggering simultaneous declines in both equities and bonds.
On StressTest.pro, every performance metric has a 'Real CAGR' counterpart — the compound annual growth rate after subtracting CPI inflation. A stock showing a 12% nominal CAGR during a 4% inflation period is actually delivering only about 8% in real purchasing-power terms. This view is essential for retirement planning, where the goal is not nominal wealth but real spending power.