The Reserve Bank of Australia has recently made an unprecedented change to the way it targets inflation.

The bank's mandate is to use monetary policy to keep a lid on price rises and achieve full employment. It does this by targeting an inflation rate of between 2 and 3 per cent a year, on average over the economic cycle.

For 27 years, it has done this by looking forward, aiming to set rates based on its forecasts of where inflation might land.

In November last year however, it announced a change in approach1.

The RBA said it will instead be watching for actual – not forecast – inflation to be in the target range. Only then will it be the right time to lift interest rates from their all-time lows.

After years of pre-emptively moving to contain inflation, the RBA is now holding off until the sleeping dragon awakes before it springs into action.

So what exactly is inflation? Why is the RBA so keen to see it return?

And more importantly, what does this all mean for investors?

Simply put, inflation is merely a term for rising prices. Its counterpart, deflation, is the term for falling prices.

Inflation and deflation are measured in Australia using the Consumer Price Index which, much like a stock market index, simply averages out a range of prices.

But unlike a stock market index, which averages the prices of a group of shares, an inflation index averages the prices of the goods and services used by households.

The consumer price index is calculated by the Australian Bureau of Statistics and covers an enormous range of purchases – from rent and mortgages to healthcare, clothing and even pet food.

The ABS collects around 100,000 prices every quarter and revises the index annually based on the actual spending of Australian households2.

Inflation has been a feature of economies through history, often occurring in bursts of surging prices and collapsing currencies as governments issued money to finance wartime spending3.

But getting prices and currencies sharply lower often came at a real cost to the regular population, who would suffer unemployment, reduced incomes and sometimes even food shortages.

Central banks, and economists, argue that keeping prices rising modestly creates conditions for the best economic outcome. Rising prices encourages investment by businesses. It boosts consumer demand and consumption because individuals purchase products before they get more expensive.

So as such, the RBA aims to achieve an inflation rate averaging between 2 per cent and 3 per cent a year.

But what does all this have to do with investing?

Inflation reduces the value of savings because the things we are saving for – whether that's a home, a holiday or retirement – will cost more by the time we get around to buying them.

Right now, this is not having too much of an effect. The Reserve Bank forecasts the inflation rate to stay low over the next few years, rising to an annual rate of only 1.5 per cent by 2022.

But the bank has committed to getting inflation higher, saying it will keep interest rates at rock bottom until the rate of inflation is sustainably within the 2 to 3 per cent target range.

And even if the RBA was not on the case, the trillions in government stimulus and central bank support being pumped into the global economy also risks sparking a jump in inflation.

This poses a challenge for investors.

An annual inflation rate of 1.5 per cent cuts the value of a dollar by 14 per cent every decade. At 3 per cent inflation, every decade that passes cuts the value of a dollar by a little over a quarter.

Older investors will recall that at one stage during the 1970s inflation breakout, inflation in Australia reached an incredible 17.5 per cent4.

In fact, for a full two decades up until the end of the 1980s, inflation averaged 9 per cent per year, meaning that, over the period, cash lost a hard-to-comprehend 85 per cent of its purchasing power.

While we are not expecting a return of such corrosive price rises, it may still be worthwhile to consider potential hedges for modest inflation.

Depending on whether higher inflation is accompanied by higher or lower economic growth5, investors' choice of instruments to hedge inflation may vary.

Under a high growth-high inflation scenario, traditional cash and fixed income investments without built-in inflation protection fare poorly, with their fixed dollar returns unable to recoup the purchasing power lost to inflation. However, these safe-havens could still play an important role in the event of a stagflation scenario – where higher inflation coincides with lower growth and persistently high unemployment.

Equites get a mixed report card. In a high growth-high inflation scenario, expected returns on equity would be high, causing the frontier to be steep. Long and short rates would also rise faster than expected, resulting in an optimal portfolio with higher allocation to equity relative to the baseline. Conversely, a low growth-high inflation environment would prove to be less conducive for equities as companies may struggle to raise output prices even as their input prices rise.

Commodities have historically performed well during inflation because as inputs, their prices tend to rise alongside the goods and services they are used to make. Gold is considered a store of value because it is so scarce. Its value rises alongside inflation. But commodities also make quite volatile investments, do not normally generate an income and can spend long periods underperforming.

Real estate investments are touted as an inflation hedge as their value usually keeps pace with prices and rents can be adjusted upwards as prices rise. But real estate also suffers from the fact that the cost of things like maintenance, property management, insurance and taxes tend to also rise with inflation. And when the RBA is satisfied inflation has returned, it will respond with higher interest rates, with directly affects the real estate industry.

In any case, ultimately when preparing a portfolio the key thing to keep in mind is that the future you plan for may or may not occur.

A portfolio prepared for one set of economic circumstances will likely underperform during another.

This means that a properly diversified portfolio will provide most people with the best combination of performance and risk, whether or not the old enemy of inflation threatens again.

Vanguard Australia