Inflation: the cost of doing nothing
Inflation is the general rise in prices. Understanding it helps you judge whether an investment really makes you money or only half-protects you.
Inflation is the general, sustained rise in prices. In Mexico it's measured by INEGI with the National Consumer Price Index (INPC), which tracks the price of a basket of goods and services that households buy. When you hear that "annual inflation was 4%", it means that basket costs 4% more than a year ago.
Why it matters even if you don't invest
If prices rise and your money doesn't, each year you buy less with the same amount. With 4% inflation a year, $100,000 kept with no return will buy in 10 years what about $67,500 buys today. You didn't lose bills, but you did lose purchasing power.
Nominal return and real return
The return you're quoted (for example, "10% a year") is the nominal one. What you actually gain in purchasing power is the real return: what's left after subtracting inflation.
Real return ≈ nominal return − inflation
If an investment gives you 10% and inflation is 4%, your real return is almost 6% (the exact math gives 5.8%). If it gives you 3% with 4% inflation, even though you see positive numbers on your statement, you're actually losing purchasing power.
| Nominal return | Inflation | Approximate real return |
|---|---|---|
| 10% | 4% | +6% |
| 6% | 4% | +2% |
| 3% | 4% | −1% |
| 0% (cash) | 4% | −4% |
What drives inflation
- Demand: if people and companies want to buy more than the economy produces, prices rise.
- Costs: if energy, food or the dollar go up, companies pass those costs on to prices.
- Expectations: if everyone expects prices to rise, they ask for raises and adjust prices in advance.
The Bank of Mexico (Banxico) has the mandate to keep inflation low and stable; its target is 3% a year, with a one-point band above or below. Its main tool is the interest rate: when inflation rises, it tends to raise rates to cool spending. We cover this in the interest rates lesson.
How an investment protects itself from inflation
- Inflation-linked instruments: in Mexico there are Udibonos, government bonds in UDIS, a unit that rises with inflation.
- Stocks: in the long run, many companies can raise prices with inflation, and their profits and value tend to grow. In the short run, high inflation can hurt the stock market.
- Short-term fixed income: short CETES roll over at the current rate, which tends to rise when inflation rises.
Test what you learned
1. An investment returns 6% and inflation is 4%. What's the approximate real return?
- 10%
- 2%
- −2%
Show the answer
2%. Real return ≈ 6% − 4% = 2%.
2. Which institution measures inflation in Mexico?
- INEGI
- CNBV
- SAT
Show the answer
INEGI. INEGI publishes the INPC; Banxico uses it for its policy.
3. What are Udibonos?
- Shares of food companies
- Government bonds that rise with inflation
- Home loans
Show the answer
Government bonds that rise with inflation. They're in UDIS, a unit that adjusts with inflation.
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Everything in this section is educational: it explains how investing works, it doesn't tell you what to buy.