How Inflation is Reshaping Household Wealth in Europe
Introduction: Why Inflation Matters in Europe Today
Inflation has become a pressing issue for households across Europe. Post-pandemic stimulus packages, supply chain disruptions, and the ongoing energy crisis have contributed to rising prices, impacting savings and investments. Understanding inflation’s effects and learning how to navigate there are crucial for investors.
What is Inflation?
Inflation is an invisible force that reduces the value of money, eroding its purchasing power over time. It penalizes savers and rewards those who borrow and invest in the right assets. In simpler terms, inflation means your money buys less than it did in the past.
Historically, inflation isn’t a new phenomenon. Ancient Rome debased its currency by mixing cheap metals into gold coins. Similarly, hyperinflation in Germany during the 1920s and stagflation in the UK in the 1970s offer lessons for today’s investors.
Who Creates Inflation and Why?
Before understanding who creates inflation, it is crucial to examine the relationship between governments, central banks, and commercial banks. While central banks, like the European Central Bank (ECB), claim independence, their policies are deeply connected to government objectives.
Central banks create money digitally by expanding their balance sheets, mainly through bond purchases and lending to commercial banks. However, the majority of money in circulation is created by commercial banks through lending. In the Eurozone, over 90% of the money supply exists as digital deposits rather than physical cash, fueled by bank loans rather than direct central bank issuance.
This system allows governments to finance debt at lower interest rates, as central banks indirectly support bond markets. However, increasing the money supply—whether through central bank policies or commercial bank lending—can erode purchasing power, devaluing the currency and diminishing household wealth over time.
Regional Impacts: How Inflation Varies Across Europe
Inflation trends across Europe reveal significant regional disparities. These differences are shaped by various economic, structural, and policy factors.
Eastern Europe has witnessed the steepest rise in inflation, particularly since 2021. This surge can be attributed to the widespread use of non-euro currencies, which amplifies currency volatility and inflationary pressures. Additionally, supply chain disruptions and energy price shocks have disproportionately affected the region. Rapid economic growth in some countries has also driven up wages, further exacerbating domestic inflation.
In the Nordic countries, inflation has been fueled by higher energy prices, robust welfare systems, and rising wages. Aggressive carbon pricing and environmental policies have increased energy and transportation costs, driving inflation. Despite their strong economies, these factors have made the Nordic region more susceptible to inflation than expected.
Germany, Austria, and Switzerland have maintained moderate and stable inflation trends. This stability is a result of disciplined fiscal policies, industrial strength, and diversified economies supported by strong export sectors. The DACH countries’ effective monetary policies and the stability of the euro have further contributed to their controlled inflation rates.
Southern Europe has shown a more volatile inflation pattern but remains less affected than Eastern Europe. Economic challenges, high unemployment, and reliance on tourism have kept inflation levels relatively lower. Slower wage growth and weak consumer demand, driven by lower disposable incomes and economic stagnation, have dampened price pressures. The gradual recovery of tourism-dependent economies has further moderated inflation in this region.
Winners and Losers in an Inflationary Economy
Winners:
- Governments: Inflation reduces the real value of public debt, making it easier for governments to repay with "cheaper" money.
- Borrowers: Loans become less burdensome over time as inflation decreases the real value of debt.
- Investors: Those who invest in inflation-resistant assets, such as real estate or commodities, often see gains.
- Exporters: A weaker currency can make European exports more competitive globally.
Losers:
- Savers: Keeping money in a bank erodes its value over time.
- Workers with Fixed Wages: Salaries that don’t keep pace with inflation reduce real income.
- Debt Investors: Low-interest rates and inflation diminish returns on government bonds.
As highlighted in the chart below, households with most of their financial assets in “Currency & Deposits” are losing wealth compared to those who allocate more to “Equities & Investment Funds.” Countries like Slovakia, Malta, and Greece have higher proportions of household assets in deposits, making their households more vulnerable to wealth erosion. Conversely, countries like Denmark and Sweden have larger allocations in investment funds and equities, allowing households to better preserve and grow wealth.
The chart emphasizes the critical importance of portfolio diversification during inflationary times. Households heavily reliant on bank accounts experience significant real wealth losses, while those with investments in equities, funds, or inflation-resistant assets fare much better. The worst financial strategy in inflationary periods is keeping all money in bank deposits. A diversified portfolio with exposure to growth and inflation-hedging assets is key to preserving and growing wealth.
Why Does Inflation Matter for Investors?
Inflation is not just an abstract economic concept; it directly impacts the cost of living and investment decisions. For investors, understanding inflation is critical because it sets the baseline for returns.
When inflation outpaces investment growth, even seemingly "safe" options, like savings accounts or bonds, can result in a loss of purchasing power. As such, inflation compels individuals to invest in assets that can outpace it, albeit with increased risk.
Monetary Illusions
One of the most misunderstood aspects of inflation is the difference between nominal and real returns. Nominal returns are the stated gains from an investment, while real returns account for inflation. For example, an investment yielding 3% nominal returns in an environment with 5% inflation actually results in a 2% loss in real purchasing power. This distinction is vital for making sound financial decisions, especially in high-inflation periods.
Real estate is a favorite investment among Europeans, often viewed as a reliable store of value. However, the chart above highlights a critical disparity between nominal and real estate prices across the European Union (27 countries). While nominal prices have reached all-time highs, real prices—adjusted for inflation—are back to levels last seen in 2019.
This divergence reveals an essential truth: much of the recent price appreciation in real estate is driven by inflation rather than actual increases in property value. For investors, this means:
- The “growth” in nominal real estate prices might not translate into real wealth gains.
- Inflation erodes purchasing power, making it critical to consider inflation-adjusted returns when evaluating real estate or other investments.
Understanding this dynamic emphasizes the importance of looking beyond surface-level returns and focusing on real gains, ensuring your investments truly grow your wealth over time.
Protecting Wealth from Inflation
Inflation forces us to invest. The goal is to identify assets that can outpace inflation while managing risk.
- Inflation-Linked Bonds: Many EU governments issue bonds that adjust for inflation, offering a hedge against rising prices.
- Stock Markets: While stocks can offer long-term growth, periods of stagflation or economic downturns can lead to underperformance relative to inflation.
- Real Estate: Europeans often favor real estate as a hedge against inflation, but in the current market, rising interest rates and property values make this a riskier proposition.
- Gold and Commodities: These traditional inflation hedges often perform well during times of economic uncertainty.
- Crypto Investments: Though speculative, cryptocurrencies are increasingly being explored as a hedge by younger investors.
Conclusion
Inflation is an unavoidable force shaping the financial landscape, and its effects ripple through every facet of personal wealth and investment strategy. For investors, understanding the nuances of inflation—how it varies regionally, erodes purchasing power, and impacts asset classes—is critical to preserving and growing wealth.
To navigate inflation effectively:
• Diversify Your Portfolio: Avoid over-reliance on bank deposits or single-asset investments. Include inflation-resistant assets like equities, inflation-linked bonds, and commodities.
• Focus on Real Returns: Nominal gains can be misleading during high-inflation periods. Always evaluate the inflation-adjusted performance of your investments.
• Stay Informed: Monitor regional inflation trends and economic policies to make informed decisions aligned with the realities of your region.
By taking a proactive approach, retail investors can turn inflation from a threat into an opportunity, protecting their wealth while capitalizing on the opportunities it creates. The key is to remain flexible, well-informed, and diversified, ensuring long-term financial resilience in an ever-changing economic environment.
Curious to see how inflation has impacted your savings or what potential gains you could achieve? Discover it with our interactive tool!