Inflation doesn’t just raise prices at the grocery store. For investors, it erodes real returns, drives interest rates higher, and exposes which businesses can protect themselves — and which ones can’t.
Imagine you invest $10,000 today and earn a solid 7% return over the next year. At year’s end, you have $10,700. You made money, right?
Not necessarily.
If inflation ran at 5% over that same year, then everything in the economy got 5% more expensive while your money was working. Your $10,700 now buys roughly what $10,200 would have bought a year ago. Your real gain — the increase in your actual purchasing power — was about $200, not $700.
That gap between your nominal return (what your account shows) and your real return (what you actually gained in purchasing power) is the first thing you need to understand about inflation. It’s not an abstract economic concept. It directly affects what you walk away with.
What Inflation Is
Inflation is a general rise in the price level — the average cost of goods and services across an economy — over time.
In the United States, the most commonly cited measure is the Consumer Price Index, or CPI: a standardized basket of hundreds of goods and services — food, housing, transportation, healthcare, and more — that the government tracks month by month. When people say “inflation is running at 4%,” they mean the CPI rose about 4% over the previous twelve months.
A related measure is the Personal Consumption Expenditures index (PCE), which the Federal Reserve typically prefers because it adjusts more fluidly as people substitute between goods when prices change. The two numbers tend to be similar, with PCE often reading slightly lower.
What inflation measures is not any one price — your rent might be up 10% while gasoline is flat. It measures the average across everything. For investors, the specific number matters less than its direction and persistence. A brief spike that reverses in six months is very different from inflation that stays elevated for several years. The latter is what reshapes markets.
The Double Barrel — Inflation and Interest Rates
Before we go further, you need to understand a connection that ties this post directly to Part 2: inflation and interest rates move together, and the combination hits investors from both directions at once.
When inflation rises and stays elevated, the Federal Reserve typically responds by raising interest rates. Higher rates are the Fed’s primary tool for cooling price pressures: when borrowing costs go up, consumers spend less, businesses invest less, demand cools, and prices stop rising as fast.
But as you saw in Part 2, rising interest rates have a direct mechanical effect on stock valuations. When the discount rate rises — the rate used to translate future earnings back into today’s dollars — the present value of future earnings falls, even if those earnings themselves haven’t changed at all.
So inflation hits investors twice:
- Directly — it erodes the purchasing power of your returns. An 8% nominal gain in a 5%-inflation year is really only a 3% gain in terms of what you can actually buy.
- Indirectly — by pushing the Fed to raise interest rates, inflation triggers the valuation compression covered in Part 2. Future earnings get discounted more heavily, and stock prices fall — even for businesses that are performing exactly as expected.
The 2021–2022 period showed this vividly. Inflation reached 40-year highs. The Fed responded with the fastest series of rate hikes in four decades. Stocks — especially high-growth companies whose value was concentrated in distant future earnings — fell sharply. The two forces worked together. If you haven’t read Part 2, the mechanism there and the mechanism here are directly linked: understanding one makes the other clearer.
Real vs. Nominal — Always Do the Math
Nominal returns are what your brokerage account shows: the percentage gain before adjusting for inflation.
Real returns are what you actually gained in purchasing power. The approximation:
Real Return ≈ Nominal Return − Inflation RateThis is slightly simplified. The exact formula is: (1 + Nominal) ÷ (1 + Inflation) − 1. But for most practical purposes, the subtraction gets you close enough.
Here’s why it matters enormously over time. The entire logic of long-term investing depends on compounding — earning returns on your returns, year after year, until small annual gains become large long-run wealth. But if your nominal return is 7% and inflation is 4%, you’re compounding real wealth at only about 3% per year. That difference is enormous over decades.
Historically, U.S. stocks have returned roughly 10% per year in nominal terms. Inflation has averaged around 3%. So the long-run real return on equities has been roughly 7% per year. That 7% figure is what’s actually growing your purchasing power. It’s the number that matters for your long-term financial position — not the 10%.
When comparing investment returns or evaluating whether a portfolio is growing enough to meet your goals, always do the inflation adjustment. The nominal number can look impressive while the real number is quite modest.
Not All Companies Are Equal — Pricing Power Is Everything
Here’s where inflation analysis gets interesting for investors. Inflation doesn’t hurt all businesses the same way. The key variable is pricing power — the ability to raise prices without losing customers.
A company with strong pricing power can pass its rising costs on to customers. When input costs go up — raw materials, wages, energy — it raises prices to match. Its margins stay intact. Its revenues rise with inflation. Its real earnings hold up.
A company without pricing power gets squeezed. Costs rise, but it can’t raise prices without driving customers to competitors. Margins compress. Real earnings shrink. The business is effectively subsidizing its customers’ inflation experience out of its own profits.
What determines pricing power?
- Brand strength. Consumers pay more for a trusted brand even when cheaper alternatives exist. This is one reason consumer staples companies — makers of dominant household and food brands — have historically held up well in inflationary periods. The brand is a cushion.
- Switching costs. If customers would face significant cost, disruption, or risk in switching to a competitor, the company can raise prices without losing them. Software providers deeply integrated into their customers’ workflows, specialized industrial equipment makers, and businesses embedded in their customers’ processes tend to have this advantage.
- Essential products. Companies selling things people genuinely must have — healthcare, utilities, basic food staples — can absorb price increases without driving away demand. People don’t stop taking their medication because the price went up 5%.
- Commodity products. At the opposite end, companies selling undifferentiated goods competing purely on price have essentially no pricing power. If customers can buy the identical product from a competitor for a dollar less, any price increase drives them away.
This is one reason investors place such premium value on businesses with durable competitive advantages — economic moats, as Warren Buffett calls them. Moats protect pricing power. And pricing power is what protects real earnings when inflation runs hot.
Capital-Intensive Businesses Face an Extra Headwind
There’s a second layer to the inflation problem for businesses that own large amounts of physical assets — factories, equipment, vehicles, real estate.
In Part 3 of our Financial Statements series — where we covered the balance sheet — we discussed the gap between depreciation (the annual accounting charge that spreads the original cost of an asset over its useful life) and the true cost of maintaining that asset. The gap exists because depreciation is based on the historical price the company originally paid, not what it would cost to replace the asset today.
Inflation widens that gap, sometimes dramatically.
Imagine a company that bought a machine for $1 million in 2010. It’s depreciated over 20 years, so the income statement shows a $50,000 annual depreciation charge. But in 2025, that same machine costs $1.8 million to replace — because manufacturing input costs and labor have risen over the intervening fifteen years. The actual annual cost to maintain that asset, in economic terms, is closer to $90,000 per year, not $50,000.
During inflationary periods, this means the income statement for capital-intensive businesses looks better than reality. Reported earnings are overstated because depreciation is understated relative to true replacement costs. Free cash flow is a more honest measure, but even it doesn’t fully capture the replacement cost gap over the long run.
This is one reason Warren Buffett has written extensively about inflation’s hidden tax on businesses that require heavy physical reinvestment. The companies that hold up best in inflationary environments are often the ones that require the least physical reinvestment to maintain their competitive position — and therefore face the smallest gap between reported costs and true costs.
Inflation Affects Asset Classes Differently
It’s worth understanding how inflation interacts with different types of investments, because this shapes how investors think about portfolio construction during inflationary periods.
Bonds are particularly vulnerable to inflation. A bond pays a fixed interest rate — say, 4% per year for twenty years. If inflation rises to 6%, that fixed payment buys less and less in real terms every year. The real return on the bond is negative. This is why bond prices fall sharply when inflation rises: newly issued bonds must offer higher rates to attract investors, which makes existing lower-yielding bonds less attractive and drives their prices down. (This is the present-value mechanism from Part 2, applied to bonds.)
Stocks are better than bonds over the long run in inflationary environments — if the companies behind the stocks have pricing power. A business that earns $50 per share today and can raise prices alongside inflation might earn $55 per share in a 5%-inflation year. That growth partially protects purchasing power in a way that a fixed bond coupon simply cannot.
But not all stocks, and not consistently in the short run. As we covered in Part 2, high-growth companies with most of their value in distant future earnings — long-duration stocks — are hit hardest by the rate rises that follow inflation. In inflationary periods, investors often rotate toward businesses with near-term earnings and strong pricing power, and away from companies whose entire investment case is built on earnings still many years in the future.
Real assets — commodities, real estate, infrastructure — have historically held up relatively well against inflation because their prices tend to move with the general price level. Energy companies, farmland, toll roads: these assets produce something with intrinsic value that inflates alongside the broader economy. They’re not simple solutions — they come with their own risks and complexities — but they represent one reason institutional investors increase their real asset exposure during inflationary periods.
What This Means in Practice
You do not need to forecast inflation to invest well. Professional economists and Fed officials who do this for a living are wrong more often than they’re right — sometimes spectacularly so. The 2021 inflation surge was almost universally characterized as “transitory.” It lasted nearly three years.
What you do need is the habit of asking, for any business you’re analyzing: can this company protect its real earnings when prices are rising?
The questions that matter:
- Does this business have pricing power? Can it raise prices without losing customers to competitors?
- What is the relationship between reported depreciation and true replacement cost? Does inflation widen that gap significantly?
- How capital-intensive is the business? The heavier the physical asset base, the more inflation acts as a hidden drag on real earnings.
- Is most of its value concentrated in near-term cash flows or in distant future earnings? Higher inflation tends to raise interest rates, which hits long-duration stocks harder — as we saw in Part 2.
Businesses that hold up through this analysis — strong pricing power, low maintenance capital requirements, near-term earnings — tend to protect real value better in inflationary environments than businesses that fail it. That’s not a prediction about when inflation will arrive or how high it will go. It’s just knowing what kind of business you own.
A Note to Luca and Lili
You will live through inflationary periods. They arrive unpredictably, last longer than most people expect, and generate an enormous amount of alarming noise — in the financial news, in conversations with people you respect, in the general mood of the market — while they’re underway.
Here’s the discipline to hold onto.
Inflation, by itself, doesn’t make good businesses less valuable. A business with genuine pricing power and low capital intensity can grow its earnings alongside rising prices. Its real value stays largely intact, even while the headlines are alarming.
What inflation does is expose weaknesses — businesses that can’t pass costs through, businesses carrying heavy physical asset burdens, businesses so dependent on cheap borrowed money that rising rates threaten their survival. Those businesses genuinely do lose real value in inflationary periods. The discipline is in knowing which kind you own.
Your advantage isn’t in predicting when inflation will arrive or what the Fed will do next. Your advantage is in building a portfolio of businesses that are structurally protected: ones that can raise prices, don’t require constant heavy reinvestment, and aren’t dependent on any particular interest rate environment to justify their valuations. Those businesses exist. Finding them is the work.
— Papa
The One-Paragraph Summary
Inflation is a general rise in the price level that erodes the purchasing power of money over time. The distinction that matters for investors is between nominal returns (what your account shows) and real returns (nominal return minus the inflation rate) — over decades, the difference is enormous and compounds relentlessly. Inflation hits stocks through two mechanisms: directly, by eroding the real value of future earnings, and indirectly, by prompting the Federal Reserve to raise interest rates, which compresses valuations through the discounting mechanism covered in Part 2. Not all businesses are equally exposed: companies with strong pricing power — the ability to raise prices without losing customers — can protect their real earnings when costs rise; companies without it face margin compression and real earnings decline. Capital-intensive businesses face an additional challenge: inflation widens the gap between reported depreciation (based on historical asset costs) and the true replacement cost of those assets, making their earnings appear more resilient than they actually are. The practical question for any investment: can this business protect its earnings when prices are rising? Strong pricing power, low capital intensity, and near-term earnings concentration are the structural characteristics that provide that protection — and they’re what to look for rather than trying to predict where inflation is headed next.
Next: Part 4 — The Business Cycle. We’ve seen how interest rates and inflation affect what investors are willing to pay for stocks. Part 4 takes the next step: the business cycle — why economies expand and contract, why markets consistently price those turning points before the economic data confirms them, and what that means for investors who try to time them.
— Jim