Purchasing power is a concept used to express the amount of goods and services a consumer or business can buy with a given unit of currency. In the United States, purchasing power is directly linked to the value of the dollar.
Due to inflation, a dollar today typically won’t go as far as it did last year. And a dollar next year won’t buy the same things that it did this year. This fluctuation in US dollar purchasing power is constant, and goes unnoticed, except in times of extreme inflation.
How Does Purchasing Power Impact Investors?
Once you understand the purchasing power definition, you can start to understand its context for investing. The purchasing power of a dollar affects investors because it makes an impact on virtually every aspect of the broader economy. When the dollar buys less, it changes the shopping decisions of consumers, the hiring practices of employers, the strategic decisions of corporations, and the monetary policy of the Federal Reserve.
One way to track inflation and purchasing power of a dollar is the Consumer Price Index (CPI), a statistic compiled by the US Bureau of Labor Statistics (BLS), which reports the figure every month. The statistic measures the average of prices of a set of goods and services in sectors such as transportation, food, and healthcare. Economists consider it a valuable gauge of the ever-changing cost of living, though it does exclude some important spending categories, including real estate and education.
Investors, executives and policymakers use CPI as a lens through which to scrutinize other economic indicators, including sales numbers, revenues, earnings and so on. It also determines the payments made to the millions of people on Social Security, which gets adjusted for the cost of living every year, and retirees drawing a pension from the military or the Federal Civil Services.
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Why Does the Value of the Dollar Change?
A number of factors drive the value of the US dollar, including large scale factors having to do with economic cycles, government politics and international relations. But the dollar has also experienced inflation for most of the last century.
Inflation rose after World War I amid increased demand for food and other raw materials, which raised prices of most consumer goods up until the Great Depression, in which the country experienced prolonged deflation.
That’s when President Franklin Roosevelt stepped in with a surprising policy decision: He banned private ownership of gold, and required people to sell their holdings to the government. That allowed the Federal Reserve to increase the money supply and stop deflation in its tracks.
Since 1933, through World War II, the Cold War, and a host of changing monetary and economic policies, the US dollar has seen various rates of inflation. It reached its peak during the late 1970s and early 1980s oil and gas shortages exacerbated existing inflation and led to a gas shortage, and an increase in the price of manufacturing and shipping of nearly every single consumer good.
Inflation rose at a more steady pace through the 1990s, falling to historically low levels in the past decade. One reason for the ongoing inflation is that the Federal Reserve continually increased the money supply via economic stimulus. The logic is simple supply and demand: If there are more dollars, then each one is worth less in terms of purchasing power.
In response to the Covid-19 pandemic and the ensuing lockdowns, the Federal Reserve injected trillions into the economy. That, along with other stimulus measures, has had many investors worried about the impact on the purchasing power of the dollar, and what that might mean for the broader economy. In 2022, inflation rose at the fastest pace in 40 years, making prices more expensive and resulting in many consumers having less money to spend.
What Purchasing Power Means for Investors
Generally, investors consider inflation a headwind for the markets, as it drives up the costs of materials and labor, boosts the cost of borrowing and tends to reduce consumer spending. That all tends to translate to lower earnings growth, which can depress stock prices.
But after decades of steady inflation, the markets have priced in a certain amount of shrinkage when it comes to the purchasing power of the dollar. Inflation has a great impact when it occurs suddenly and unexpectedly.
But inflation can have benefits for investors as well. During an economic upswing, inflation is a reliable side effect of prosperity, since economic booms produce higher profits, which drives up the markets. Historically, some experts say that the decades when the S&P 500 Index has delivered the highest returns have been when inflation has been between 2% to 3% annually.
Investors saving for long-term goals, such as retirement, must take declining purchasing power into account when determining how much they’ll need to reach those goals.
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How Does Inflation Influence Stocks?
Inflation impacts different types of stocks differently, and there are several strategies that investors can use to hedge against inflation. During periods of high inflation, growth stocks tend to underperform, simply because so much of their value is tied up in the expectation of future earnings, and inflation diminishes those expectations.
Value stocks, on the other hand, typically boast steadier earnings, and are valued in line with those earnings. As a result, value stocks, as a category, tend to hold up better during periods of high inflation.
Other investments to consider during periods of high inflation include dividend-paying utility stocks and REITs, gold and other commodities. And because periods of high inflation usually brings higher interest rates, it can be a good time to buy bonds, especially government bonds
The Takeaway
The value of the dollar, in terms of what it can buy, changes over time, but inflation isn’t always bad news for investors. Some stocks may perform better than others in an inflationary environment, and higher interest rates may be good news for bond investors and savers.
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