The Investment Dilemma in the Era of Inflation: How Central Bank Rate Hikes Reshape Asset Allocation Patterns

In recent years, global prices have surged, prompting central banks around the world to raise interest rates one after another, with Taiwan’s central bank increasing rates five consecutive times. Amid this wave of inflation, traditional investment strategies face challenges, and many people’s cash holdings are quietly losing value. What exactly is inflation? How should we respond? This article takes you deep into understanding the logic behind this economic shift.

Money Depreciation: Understanding the Nature of Inflation

The core of inflation is the loss of purchasing power of money. Over a period, as the prices of goods continue to rise, the same amount of money can buy fewer items. The most commonly used indicator to measure this phenomenon is the Consumer Price Index (CPI), which reflects the overall change in prices of goods and services in the market.

Simply put, inflation means your money is becoming less valuable. A cup of coffee that cost 10 yuan in the past now costs 15 yuan, so you need to spend more to buy the same product. What is the economic principle behind this?

Where Does Inflation Come From: Four Major Causes

Inflation does not appear out of nowhere; it stems from complex supply and demand imbalances within the economy. Economists have summarized the following main causes:

First: Demand-driven cycle

When consumer desire for goods increases significantly, it leads to demand-pull inflation. Businesses see opportunities, increase production and investment, and hire more employees. As employee incomes rise, further consumption is stimulated. This virtuous cycle can indeed bring economic growth, with GDP rising accordingly, which is why governments try to stimulate market demand.

Second: Cost-push inflation

Rising raw material prices directly increase production costs. During the Russia-Ukraine conflict in 2022, Europe’s energy supply was disrupted, and oil and natural gas prices soared tenfold, causing the Eurozone CPI annual rate to exceed 10%, reaching a historic high. This cost-push inflation is different from demand-pull inflation—it often accompanies economic recession, declining output, and rising unemployment, making it a headache for governments.

Third: Uncontrolled money supply

Overprinting money has been the culprit behind many hyperinflations in history. In 1950s Taiwan, to cope with post-war deficits, the Central Bank issued大量貨幣, eventually leading to 8 million Taiwanese dollars being exchanged for just 1 US dollar. When the circulating money in the market far exceeds the real economy’s needs, the inflation spiral begins to turn.

Fourth: Self-fulfilling expectations

People’s psychological expectations can also push prices higher. Once the public anticipates future price increases, they rush to buy now—today’s purchase is more expensive than tomorrow’s. This psychological drive increases consumption, businesses see opportunities and expand production, and employees demand higher wages, prompting merchants to raise prices immediately. Once this expectation-based inflation takes hold, it becomes very difficult to reverse. This is why central bank officials often make statements like “must defeat inflation”—to stabilize expectations.

Rate Hikes: A Double-Edged Sword—The Cost of Controlling Inflation

When inflation spirals out of control, central banks’ conventional weapon is raising interest rates. What changes does this bring?

Higher interest rates → Increased borrowing costs → Reduced consumption and investment → Demand weakens → Prices fall

This is the textbook logic. For example, if the previous loan interest rate was 1%, borrowing 1 million yuan would cost only 10,000 yuan annually. After raising rates to 5%, the same loan now costs 50,000 yuan annually. As a result, people tend to save rather than spend, market liquidity tightens, demand for goods decreases, and prices naturally decline.

However, the other side of this sword is very sharp. When demand weakens, companies will cut production, leading to layoffs, rising unemployment, slowing economic growth, and even recession. The 2022 US stock market vividly illustrates this: inflation hit 9.1% in June, a 40-year high. The Federal Reserve began raising rates in March, with a total of 7 hikes throughout the year, increasing by 425 basis points, pushing rates from 0.25% to 4.5%. This made financing difficult for companies, and stock valuations plummeted. The US stock market experienced its worst performance in 14 years, with the S&P 500 down 19% cumulatively, and the tech-heavy Nasdaq dropping 33%.

The Hidden Benefits of Moderate Inflation

Here’s an economic paradox: moderate inflation can actually be beneficial to the economy.

When people expect future prices to rise, their willingness to spend increases—buying today is cheaper than buying tomorrow. This psychological effect boosts consumption, prompting businesses to invest and expand, increasing employment and GDP growth. Conversely, what happens during deflation (negative inflation)? Prices stagnate or fall, people hoard cash and reduce spending, causing the economy to stagnate. Japan, after its economic bubble burst, fell into deflation, entering the “Lost Decade” in the 1990s, and has yet to fully recover.

Therefore, most central banks set inflation targets at around 2%-3% (such as the US, Europe, UK) or 2%-5% (other countries), aiming to avoid excessive inflation while preventing the economy from slipping into a deflationary trap.

Another often overlooked phenomenon: during high inflation periods, debtors can actually benefit. For example, if you borrowed 1 million yuan to buy a house 20 years ago, with a 3% inflation rate, the real value of that 1 million today is roughly equivalent to 550,000 yuan in purchasing power. The amount you owe hasn’t changed nominally, but the real burden has decreased. Therefore, those who buy assets like real estate, stocks, or gold with debt often profit most during high inflation.

Inflation’s Differential Impact on the Stock Market

Conclusion first: low inflation benefits the stock market, high inflation is a bear market. But this conclusion is not absolute.

In a low inflation environment, market liquidity is ample, and hot money flows into stocks, pushing prices higher. However, high inflation forces central banks to tighten policies, raising financing costs and depressing stock valuations. Not all sectors perform poorly during high inflation.

Historical data shows that energy stocks often outperform during high inflation. In 2022, the US energy sector’s performance was remarkable, with an overall return exceeding 60%, including Occidental Petroleum up 111% and ExxonMobil up 74%. This is understandable—rising energy prices are a key driver of inflation, and energy companies benefit accordingly.

In contrast, the overall stock market is suppressed by rising interest rates, but structural opportunities still exist. Investors need to be selective to profit during inflationary times.

Asset Allocation Strategies During Inflation

Facing inflation, proper asset allocation becomes crucial. Investors should seek diversified portfolios with assets that have inflation-hedging characteristics.

Assets that perform relatively well during inflation include:

Real estate tends to appreciate rapidly during inflation because liquidity often flows into the property market, pushing up prices.

Gold has an inverse relationship with real interest rates. When inflation rises and real interest rates (nominal rate minus inflation) fall, gold’s attractiveness increases. Historically, gold prices tend to rise with inflation.

Stock performance is more complex. In the short term, different stocks may diverge significantly, but over the long term, stock returns generally outpace inflation, especially stocks of quality companies.

Foreign currencies (like the US dollar) also tend to appreciate during high inflation. When the Fed adopts a hawkish stance and raises rates sharply, the dollar appreciates due to attracting international capital inflows.

Practically, investors can consider dividing their funds into thirds: stocks, gold, and US dollars. This combination leverages growth potential, preserves value, and hedges against inflation risks. Such diversified allocation can significantly reduce risks associated with any single asset and provide more stable long-term returns.

From Theory to Practice: Building Your Own Inflation Response Plan

After understanding inflation principles and investment directions, the key is to take action.

First, assess your current asset situation—how much cash, stocks, real estate, bonds do you hold? How will these assets perform in a high inflation environment?

Second, clarify your risk tolerance. Aggressive investors can increase allocations to stocks and energy stocks, while conservative investors should increase holdings of gold and US dollars.

Finally, review and adjust regularly. Inflation environments are constantly changing, and central bank policies are evolving. Your portfolio needs to be optimized accordingly; a static approach is not advisable.

Summary

Inflation is a persistent challenge in the economy, but also an opportunity for investors. Moderate inflation can promote economic growth, while high inflation requires central banks to raise rates to curb it. Throughout this process, different asset classes will experience varying degrees of volatility.

Investors should understand the causes of inflation, the impact of rate hikes, and build diversified portfolios including stocks, gold, and US dollars. With a correct understanding of inflation, you can protect your wealth and even grow it amid this economic shift. Remember: inflation is not the enemy; with proper strategies, it can become your ally.