Inflation

The only loss that requires no market move, arrives every year, and never appears on a statement.

The loss with no transaction

• Every other risk on this site shows up as a price change. Inflation does not: the balance is unchanged, the number on the statement is unchanged, and what it buys has fallen.
• That invisibility is why it is systematically under-managed. A 20% equity drawdown produces urgent action; 4% inflation for five years costs a similar amount of purchasing power and produces none.
• Every return in finance should be read twice — nominal, and then real. Only the second one buys anything.

How it is measured, and why your number differs

• A price index tracks a basket — a weighted set of goods and services meant to represent average consumption. Your basket is not the average one.
• Weights matter more than prices. Housing, energy and food dominate low-income budgets and are weighted for the average household, so headline inflation systematically understates the experience of those spending most on essentials.
• Substitution and quality adjustment — indices assume people switch away from what rises fastest, and adjust for products improving. Both are defensible and both reduce measured inflation, which is why methodology is politically contested.
• Core inflation strips food and energy — not because they do not matter, but because they are volatile and mean-reverting, so the remainder is a better signal of where inflation is heading. It is a policy tool, not a cost of living.
• Asset price inflation is not in the index at all. House prices enter mainly through rents. A decade in which assets tripled and the index rose 20% is not a contradiction — the index was never measuring that.

Indexation: what a rising payment is worth

Pensions, rents, wages and some bonds escalate with inflation. The value of that escalation is roughly the inflation rate times the duration of the payment stream — a large number over decades and easy to give away in a negotiation.

Inflation-linked bonds

• The principal is uplifted by an index, and coupons are paid on the uplifted principal — so both the income and the redemption keep pace. The quoted yield is a real yield.
• The breakeven is the gap between a nominal bond's yield and a linker's real yield — the inflation rate at which the two produce the same outcome. It is the market's inflation expectation plus a risk premium, and the breakeven calculator extracts it.
• Deflation floors exist in some markets: the principal cannot redeem below par, which is a valuable embedded option in a deflationary scare and is priced accordingly.
• Indexation lags — typically two to three months — so a linker does not protect against the most recent months of inflation.
• They are still bonds. Real yields move, and long linkers have long duration: the 2022 UK experience showed that an inflation hedge can lose heavily during an inflation shock, because real yields rose faster than the index compensated. See the LDI crisis.

What historically kept up, and what did not

• The distinction that matters is shock versus regime. Almost nothing protects during an inflation shock, because rising discount rates hit everything at once — which is precisely what 2022 demonstrated. Over a full inflationary regime, real assets and equities with pricing power have historically kept pace.
• Debtors gain, creditors lose. A fixed-rate mortgage is a short position in the currency: inflation erodes the real value of what you owe. This is the largest inflation hedge most households already have and rarely recognise.

Practitioner rules

• Quote every long-horizon plan in real terms. A retirement number in nominal currency twenty years out is not a number, it is a fog.
• Take costs off the real return, not the nominal one. At 2% inflation and 5% nominal, a 1% fee is a third of the real return, not a fifth of the nominal one — the arithmetic in costs & fees gets considerably worse when read this way.
• Value indexation explicitly whenever offered a choice between a higher fixed payment and a lower escalating one.
• Do not confuse a hedge with a forecast. Buying inflation protection is buying it at the market's price, which already contains the expectation.
• The riskless asset is riskless in nominal terms only. For a long-horizon real goal, cash is the risky choice.