Inflation and Tightening: The Two Sides of Economic Phenomena Investors Must Know and How to Respond

Opening: Why Focus on Inflation and Tightening?

In the past two years, rising prices have become a hot topic worldwide. Taiwan’s central bank has raised interest rates five consecutive times, the Federal Reserve has aggressively increased rates by 425 basis points, and the European Central Bank has not lagged behind. The driving force behind this is the persistently high inflation rate. Interestingly, not everyone suffers losses during inflation—some see their wealth shrink, while others achieve appreciation through asset allocation.

So, the key questions we need to understand are: How exactly does inflation occur? What impact does it have on the economy and investment markets? And when inflation recedes and enters a deflationary era, how will the situation change?

The Nature of Inflation: Excess Money Supply or Goods Shortage?

Inflation simply means a sustained increase in prices over a period of time, which corresponds to a continuous decline in the purchasing power of money. The most commonly used indicator to measure this phenomenon is the CPI (Consumer Price Index).

The fundamental cause of inflation is only one: the amount of money in circulation exceeds the economic output. Too much money chasing too few goods naturally drives prices up. But how exactly does this happen? We can summarize it into four main driving factors:

1. Demand-Pull Inflation
When consumers’ desire to buy goods increases, businesses expand production, leading to more investment and hiring. As profits rise, wages increase, which in turn boosts consumption—a positive feedback loop. Although prices rise, GDP also grows, and the economy flourishes. A classic example is China in the early 2000s: when CPI rose from 0 to 5%, GDP growth jumped from 8% to over 10%.

2. Cost-Push Inflation
Inflation caused by soaring raw material prices. During the Russia-Ukraine conflict in 2022, Europe couldn’t import Russian oil and natural gas, energy prices skyrocketed tenfold, and the Eurozone’s CPI inflation rate exceeded 10%, hitting a record high. The problem with this type of inflation is that—despite rising prices—overall social output actually declines, GDP shrinks, and businesses face stagflation.

3. Excessive Money Printing
Governments printing money uncontrollably—many historical hyperinflations stem from this. In Taiwan during the 1950s, to cope with post-war deficits, banks issued大量貨幣, leading to 8 million old dollars being worth just 1 US dollar—prices soared, and the currency collapsed.

4. Self-Fulfilling Expectations
When people expect prices to keep rising, they spend in advance, demand higher wages, and merchants raise prices accordingly. Once inflation expectations form, they spread like a virus, becoming difficult to shake.

Central Bank Rate Hikes: Cure for Inflation or Poison for the Economy?

When prices spiral out of control, central banks typically respond with interest rate hikes—raising the benchmark rate. The logic is straightforward:

Higher interest rates → increased borrowing costs → people prefer saving over spending → demand weakens → goods sell less → businesses cut prices → inflation is controlled.

The numbers are clear: if loan interest rates rise from 1% to 5%, borrowing 1 million dollars previously cost 10,000 per year, now it costs 50,000. Who would dare borrow easily? Capital shrinks, markets cool down, and prices naturally fall.

However, this policy also has hidden costs. When demand weakens, companies stop hiring or even start layoffs. Unemployment rises, economic growth slows, and sometimes a crisis ensues. The 2022 US stock market is a textbook example: after seven rate hikes by the Fed, the S&P 500 fell by 19%, and the Nasdaq plunged 33%. While rate hikes curb inflation, they also break the stock market.

The Other Side of Inflation: Fuel for Economic Growth

Here’s a counterintuitive truth: moderate inflation can actually benefit the economy.

When people expect prices to rise, their consumption increases, stimulating demand and encouraging investment. As a result, production expands, and GDP grows. Conversely, deflation (persistent falling prices) has the opposite effect.

Take Japan as an example: after the burst of the economic bubble in the 1990s, Japan fell into deflation. With prices barely rising, consumers hoarded cash, preferring savings over spending. Demand collapsed, GDP contracted, and Japan entered the “Lost Thirty Years”—the most severe consequence of deflation.

Because of this, central banks worldwide aim to keep inflation within a reasonable range: 2%-3% in the US, Europe, UK, Japan, Canada, Australia, and 2%-5% in many other countries. This range can stimulate economic vitality without spiraling out of control.

Who Benefits from Inflation?

People with debt.

It sounds counterintuitive but is entirely logical. Suppose you borrowed 1 million 20 years ago at a 3% inflation rate to buy a house. Today, that 1 million has depreciated to about 550,000 in real terms, so you only need to repay roughly half the original debt. Debtors use devalued currency to pay off loans, significantly reducing their debt burden.

Furthermore, they can leverage assets—not just real estate but also stocks, gold, etc. During high inflation, asset values appreciate rapidly, while debt repayment becomes easier. This is the golden age for leveraged investors.

Conversely, cash holders are the victims. Their money depreciates, purchasing power declines, and if they do not diversify assets, their wealth is gradually eroded by inflation.

How Does Inflation Impact the Stock Market? What Should Investors Do?

During low inflation, stocks tend to rise; during high inflation, stocks usually fall.

In a low-inflation environment, central banks maintain loose policies, capital is abundant, and hot money flows into stocks, pushing prices higher. High inflation forces central banks to tighten, raising interest rates, increasing corporate financing costs, and lowering stock valuations.

But high inflation doesn’t mean investors should stay away from stocks. Historical data reveals an opportunity: energy stocks tend to perform surprisingly well during high inflation.

In 2022, the US energy sector returned over 60%. Occidental Petroleum (OXY) surged 111%, ExxonMobil (XOM) rose 74%. Why? Because oil prices are a major driver of inflation—higher oil prices mean higher profits for energy companies.

This suggests a strategy: in high inflation environments, shift toward energy and commodity-related assets rather than blindly holding tech stocks.

Asset Allocation During Deflation

If inflation erodes cash’s purchasing power, deflation threatens economic growth itself. Facing these extremes, investors need to build a defensive, diversified portfolio.

Here’s a comparison of assets’ performance during inflation and deflation:

A reasonable approach: diversify investments—allocate about 30% to stocks (growth potential), 30% to gold (inflation hedge), 30% to USD or high-yield bonds (defensive income), and 10% as flexible cash. This way, you participate in growth while protecting capital amid inflation and deflation swings.

Key Insight: The Cycles of Inflation and Deflation

Economic history repeatedly shows: inflation and deflation are two sides of the same coin.

Central banks raise rates to curb excessive inflation, but over-tightening can trigger deflation. Deflation then hampers growth, prompting central banks to lower rates again, increasing liquidity and prices—creating a cycle.

Smart investors don’t bet on a single direction but adapt their allocations throughout the cycle. During inflation, focus on energy and hard assets; during deflation signals, shift to defensive assets and bonds. Understanding the logic of inflation and deflation is the key to mastering the investment market.

Summary

Inflation results from excess money supply or goods shortages, with central banks raising rates to control it, often at the cost of slowing economic growth. Moderate inflation benefits the economy, but excessive inflation destroys purchasing power; deflation threatens growth itself. Investors should dynamically adjust asset allocations based on inflation and deflation environments—focusing on energy and hard assets during high inflation, and strengthening defensive holdings during risks of tightening. Only by doing so can wealth be preserved and appreciated amid the ebb and flow of the economy.