Inflation
Inflation
A sustained increase in the general price level of goods and services over time, reducing the purchasing power of money. Measured by the Consumer Price Index (CPI) in the United States. Inflation erodes the real value of fixed-income payments and cash holdings.
If inflation is 3% annually, $100 today will only buy approximately $97 worth of goods in one year, and $88.53 worth of goods in four years.
Inflation is not the same as high prices; it's the rate of change in prices over time. A 2% inflation rate means prices are rising by 2% annually, not that prices are 2% higher than normal.
How This Is Tested
- Understanding inflation as erosion of purchasing power over time
- Calculating real return by subtracting inflation from nominal return
- Recognizing which investments protect against inflation (equities, TIPS, real estate)
- Identifying the impact of inflation on fixed-income investments
- Understanding the relationship between inflation and interest rates
- Determining which asset classes are most vulnerable to inflation risk
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Federal Reserve inflation target | 2% annually (Core PCE) | Fed targets 2% Core Personal Consumption Expenditures (PCE) inflation |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Patricia, a 68-year-old retiree, has $800,000 invested entirely in long-term Treasury bonds yielding 4% annually. She is concerned about maintaining her purchasing power over a 20-year retirement. Current inflation is running at 3% annually. Which of the following recommendations would best address her primary concern?
B is correct. With only a 1% real return (4% nominal - 3% inflation), Patricia's purchasing power will decline significantly over 20 years. TIPS provide inflation protection through principal adjustments tied to CPI, while equities historically outpace inflation over long periods, making this combination appropriate for addressing inflation risk.
A fails to address the inflation concern; a 1% real return will erode purchasing power. C (money market) would provide even lower returns, likely below inflation, accelerating purchasing power loss. D (longer bonds) would increase interest rate risk and still provide fixed payments vulnerable to inflation.
The Series 65 exam tests your ability to identify inflation risk in client portfolios and recommend appropriate solutions. Understanding that fixed-income investments are vulnerable to inflation is critical for making suitable recommendations to retirees with long time horizons.
Which economic indicator is primarily used to measure the rate of inflation in the United States?
B is correct. The Consumer Price Index (CPI) is the primary measure of inflation in the United States, tracking the change in prices paid by urban consumers for a basket of goods and services over time.
A (GDP) measures total economic output, not inflation. C (PPI) measures wholesale prices paid by producers, which can be a leading indicator of consumer inflation but is not the primary inflation measure. D (Prime rate) is an interest rate set by banks, not an inflation measure, though it may respond to inflation.
The Series 65 exam frequently tests knowledge of economic indicators. Understanding that CPI is the primary inflation measure is essential for discussing inflation risk, TIPS adjustments, and economic conditions with clients.
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Access Free BetaAn investor's portfolio generated a nominal return of 8.5% last year. If inflation measured by CPI was 3.2% during the same period, what was the approximate real return?
A is correct. Real return is calculated by subtracting the inflation rate from the nominal return: 8.5% - 3.2% = 5.3%. This represents the actual increase in purchasing power after accounting for inflation.
B (11.7%) incorrectly adds inflation to the nominal return instead of subtracting it. C (2.7%) appears to use an incorrect calculation, possibly dividing instead of subtracting. D (5.1%) uses an imprecise calculation method but is close; however, the simple subtraction method (8.5% - 3.2% = 5.3%) is the standard approximation tested on the Series 65.
Real return calculations are common on the Series 65 exam. You must be able to quickly calculate the inflation-adjusted return to evaluate whether an investment is truly generating positive purchasing power gains. This is critical for assessing investment performance and setting realistic client expectations.
All of the following investments provide some degree of protection against inflation risk EXCEPT
C is correct (the EXCEPT answer). Long-term fixed-rate bonds are highly vulnerable to inflation risk because they pay fixed interest and principal that do not adjust for inflation. As inflation rises, the purchasing power of these fixed payments declines, making this the investment that does NOT provide inflation protection.
A (TIPS) explicitly protects against inflation through CPI-linked principal adjustments. B (REITs) provide inflation protection as rental income and property values typically rise with inflation. D (Common stocks) historically outpace inflation over long periods as companies can raise prices and earnings tend to grow faster than inflation.
The Series 65 exam tests your ability to distinguish which asset classes protect against versus are vulnerable to inflation. Understanding that fixed-income securities suffer during inflationary periods is essential for portfolio construction and risk management recommendations.
During a period of rising inflation, which of the following statements about investment impacts are accurate?
1. The real value of future bond payments decreases
2. Companies with pricing power can maintain profit margins
3. Money market fund yields typically increase
4. The purchasing power of cash holdings increases
B is correct. Statements 1, 2, and 3 are accurate.
Statement 1 is TRUE: Inflation erodes the purchasing power of fixed bond payments. A $1,000 coupon payment buys fewer goods and services when prices rise.
Statement 2 is TRUE: Companies with strong brands and pricing power can raise prices to offset inflation, protecting profit margins. This is why equities can serve as inflation hedges.
Statement 3 is TRUE: Money market funds invest in short-term instruments that reset frequently. As inflation rises, interest rates typically increase, leading to higher money market yields.
Statement 4 is FALSE: Cash loses purchasing power during inflation. If inflation is 3%, $100 in cash will only buy $97 worth of goods one year later.
The Series 65 exam tests comprehensive understanding of how inflation affects different asset classes. You must understand that inflation benefits borrowers and hurts lenders/savers, while variable-rate and equity investments can provide better inflation protection than fixed-rate instruments.
💡 Memory Aid
Inflation shrinks the dollar. "Fixed = Fried": Fixed-rate bonds pay the SAME dollars that buy LESS each year. "TIPS = Protected": TIPS adjust UP with CPI, equities raise prices, real estate increases rents. Protection needs flexibility.
Related Concepts
This term is part of this cluster:
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Where This Appears on the Exam
This term is tested in the following Series 65 exam topics: