Inflation Risk
The risk that inflation erodes the purchasing power of investment returns, leaving investors worse off in real terms.
What is Inflation Risk?
Inflation risk (also called purchasing power risk) is the danger that the rate of inflation will exceed the rate of return on an investment, reducing the real value of the investor's wealth. Fixed-income investments — particularly long-duration nominal bonds — are most vulnerable: a bond paying 3% annual interest loses real value if inflation runs at 4%. Cash and short-term deposits face similar erosion. Inflation risk is most severe during unexpected inflation surges, because asset prices reflect consensus inflation expectations; actual inflation above those expectations causes real losses. Assets with natural inflation hedging properties include Treasury Inflation-Protected Securities (TIPS), real estate, commodities, equities (as companies can raise prices), and inflation-linked bonds. From 2021 to 2023, US inflation reached 40-year highs near 9%, devastating the real returns of long-duration bond holders and demonstrating the practical impact of inflation risk.
Example
An investor holds a 10-year Treasury bond with a 2% coupon purchased in 2020, expecting modest inflation. By 2022, inflation reached 8%. The investor is earning 2% nominal while losing 8% in purchasing power — a real return of approximately −6%. A TIPS holder, whose principal adjusts with the CPI, is protected from this outcome.
Source: US Treasury — TIPS