Inflation

Inflation is the cost of goods and services increasing, usually measured by CPI (US) or HICP (EU). As such it would be sensible to use inflation as our baseline and focus on real returns. However, excess returns make more sense mathematically.

Inflation is a main driver of central bank policy, interest rate changes and asset prices. As such incorporating it explicitly in our model also makes a lot of sense.

Certain asset classes are nominal (fixed income) and interest rate sensitive (fixed income, equity). Others are “real”/inflation adjusted (commodities, equity, real estate, infrastructure).

There are also inflation-protected bonds (TIPS / HICP linked bonds). These are still sensitive to the interest rate though.