Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.
Several variations on inflation:
- Deflation;
- Hyperinflation;
- Stagflation.
In recent years, most developed countries have attempted to sustain an inflation rate of 2-3%.
Causes of Inflation
Demand-Pull Inflation - This theory can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies.
Cost-Push Inflation - When companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports.
Problems arise when there is unanticipated inflation:
- Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who borrow, this is similar to getting an interest-free loan.
- Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.
- People living off a fixed-income, such as retirees, see a decline in their purchasing power and, consequently, their standard of living.
- The entire economy must absorb repricing costs ("menu costs") as price lists, labels, menus and more have to be updated.
- If the inflation rate is greater than that of other countries, domestic products become less competitive.
The question shouldn't be whether inflation is rising, but whether it's rising at a quicker pace than your wages.
In some situations, little inflation (or even deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it's not so easy to label inflation as either good or bad.
Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods that are representative of the economy are put together into what is referred to as a "market basket." The cost of this basket is then compared over time. This results in a price index, which is the cost of the market basket today as a percentage of the cost of that identical basket in the starting year.
Consumer Price Index (CPI) - A measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles.
The Fed meets eight times a year to set short-term interest rate targets.
Interest rates directly affect the credit market (loans) because higher interest rates make borrowing more costly. By changing interest rates, the Fed tries to achieve maximum employment, stable prices and a good level growth. As interest rates drop, consumer spending increases, and this in turn stimulates economic growth.
It's the Fed's job to maintain that delicate balance. A tightening, or rate increase, attempts to head off future inflation. An easing, or rate decrease, aims to spur on economic growth.
The main problem with stocks and inflation is that a company's returns tend to be overstated. In times of high inflation, a company may look like it's prospering, when really inflation is the reason behind the growth. When analyzing financial statements, it's also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value inventory.
This example highlights the difference between nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power.
Conclusion :
Some points to remember:
- Inflation is a sustained increase in the general level of prices for goods and services.
- When inflation goes up, there is a decline in the purchasing power of money.
- Variations on inflation include deflation, hyperinflation and stagflation.
- Two theories as to the cause of inflation are demand-pull inflation and cost-push inflation.
- When there is unanticipated inflation, creditors lose, people on a fixed-income lose, "menu costs" go up, uncertainty reduces spending and exporters aren't as competitive.
- Lack of inflation (or deflation) is not necessarily a good thing.
- Inflation is measured with a price index.
- The two main groups of price indexes that measure inflation are the Consumer Price Index and the Producer Price Indexes.
- Interest rates are decided in the U.S. by the Federal Reserve. Inflation plays a large role in the Fed's decisions regarding interest rates.
- In the long term, stocks are good protection against inflation.
- Inflation is a serious problem for fixed income investors. It's important to understand the difference between nominal interest rates and real interest rates.
- Inflation-indexed securities offer protection against inflation but offer low returns.