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A good example of inflation can be seen by looking at the prices of certain goods during World War II. At this time, a loaf of bread cost $0.15; a new car was around $1,000; and you could buy an average house for $5,000. The current prices of these products are obviously a lot more than they were 60 years ago. This is because there has been a high level of inflation during this time period. The late 1970’s was a time of a dramatic surge in inflation rates and this was accompanied by high levels of public anxiety. Since then, inflation rates have decreased somewhat; however inflation still remains a major concern for the general public. The main reason for this concern is the fact that most people simply don’t understand why inflation occurs and how it will affect their quality of life. In this section we will consider these and other characteristics of inflation.
What Is Inflation?
Inflation is the rate of sustained increase in the prices of goods and services, measured as a percentage increase over an annual period. When there is an increase in inflation rates it means that for each dollar that you spend you will be able to buy a smaller amount of a particular product or service. Inflation means that the value of a dollar (in terms of what it can buy) is not constant. This is referred to as the “purchasing power” of the dollar. When rates of inflation rise there is a corresponding reduction in purchasing power as the money is able to buy less tangible goods.
EXAMPLE: Assume that the inflation rate of a particular economy is 2% per year. This means that a product that currently costs $2 will cost $2.04 at the same time next year. Inflation increases the price and you can’t buy the same goods with a dollar as you previously could.
Other variations of inflation are:
Deflation – this is inflation in reverse in that it refers to the decrease in prices of goods and services over time.
- Hyperinflation – this term refers to inflation that occurs at an unusually rapid pace. For example, the extreme case of Germany in 1923 where there was a 2,300% rate of inflation in a single month! This can sometimes result in the collapse of a national economy.
- Stagflation – this refers to situations where there is the co-existence of high unemployment, stagnation of the economy and high rates of inflation. An example of this occurred in industrialized countries in the 1970’s when the increase in oil prices by OPEC was combined with unhealthy national economies.
Most developed countries are currently attempting to maintain inflation rates of between 2 and 3%.
Causes of Inflation
Economists generally relish the opportunity to discuss the reasons for inflation. While there is no universally accepted cause of inflation, there are two widely approved theories:
Demand-Pull Inflation. This theory is based on situations where the demand for goods and services is increasing faster than their supply. In other words, there is a lot of money and not enough goods to satisfy the demand.. This pushes the prices up and generally occurs in economies that are experiencing growth.
Cost-Push Inflation. When the costs to produce goods and services increase, companies will need to increase their prices to maintain a margin of- profit. Some factors that may lead to increased costs for companies include taxes, increased import costs, and wages.
Costs of Inflation
Inflation isn’t necessarily always a bad thing. The impact of inflation will be different for different people, depending on whether or not it was anticipated. Where the inflation rate is anticipated (meaning that it corresponds with the rate that most people expected) then it will not have a large impact. In these situations people and institutions can take certain steps to compensate for the expected increase, for example, a consideration of the rates can be incorporated into wage increases or the interest rates that are charged by banks.
The big problems occur when inflation is unanticipated. Possible problems in these situations include:
Unfair advantages for debtors. An unanticipated rise in inflation can mean that a product bought with a loan agreement will be worth more at the time that the loan is paid than at the time of initial purchase.
- Damage to the economy based on uncertainty which results in less spending by corporations and consumers.
- A reduction in the standard of living for people who have a fixed income (retirees for example) as they have less purchasing power.
- The huge costs of re-pricing items. Updating labels, menus and other price lists is a huge expense for the economy to absorb.
- A reduction in the competitiveness of domestic products for the export market where prices would be lower in other countries.
While many people complain about the rising prices that are associated with inflation, they often don’t take into consideration the fact that they are also receiving higher wages. The main issue to consider when dealing with inflation is whether there is a balance between the inflation rate and rising wages. Another point is the reality that inflation is generally an indication of economic growth. Low inflation rates and deflation can often be a sign of a weakening or unstable economy. Labeling inflation as good or bad is a difficult exercise that may be highly dependent upon the strength of the overall economy and an individual’s personal situation.
How Is Inflation Measured?
Government statisticians are faced with the difficult task of measuring the rate of inflation. This is done by creating a sample of goods that collectively will represent the entire economy. This is known as the “market basket”. The costs involved in purchasing the goods in the market basket are compared at different points in time. The difference in the price of the market basket over a yearly period, as a percentage, is known as the “price index”.
North America measures inflation using the following two price indexes:
- Consumer Price Index. Commonly known as the CPI, this index measures the change in the price of consumer purchases such as gasoline, food, and cars. In the United States, this data is compiled by the Bureau of Labor Statistics.
- Produced Price Indexes. Also known as PPI, these are a collection of indexes dealing with the changing prices that domestic producers charge for goods and services. This data is also compiled by the Bureau of Labor Statistics in the United States.
An easy way to think of the CPI and PPI is that they are like large-scale surveys. The Bureau of Labor Statistics regularly contacts a large list of companies (such as stores, restaurants, property renters and many others) to find out what prices they are charging for specific items. They collect this pricing data for about 80,000 different goods and services every month and they use this information to measure price changes and calculate the CPI. When a long period of time is considered, the PPIs and the CPI will be a similar rate. In the short term the PPI rates will sometimes rise prior to a rise in the CPI. Investors generally rely more upon the CPI.
Inflation and Interest Rates
Inflation rate updates are usually linked with updates regarding interest rates. Interest rates in the United States are set by the Federal Reserve (also known as the “Fed”). They meet eight times each year to decide what the short-term interest rate targets should be. These decisions are largely based upon the CPI and PPIs at the time of the meetings.
The interest rates that the Fed sets are very important because they have a direct impact on the credit market. When interest rates are high, obtaining a loan costs more and borrowing is less appealing. When interest rates are lower people tend to borrow more, spend more and this results in higher levels of economic growth. Therefore it is clear that the way that the Fed changes interest rates can have dramatic implications for employment levels and overall economic stability. However, it is important to remember that extreme economic growth can be dangerous. When an economy grows rapidly it has an increased likelihood of suffering from hyperinflation. On the other hand, when there is no inflation the economy will generally stagnate. The optimal level of economic growth and inflation is between these two scenarios and the Fed is attempting to keep the economy at this level. In simplified terms, increasing interest rates (also known as tightening)an attempt to prevent excessive inflation. Decreasing interest rates (also known as easing) designed to encourage economic growth.
Inflation is only one of the factors that influence the Fed when they are setting interest rates. Another factor (and one that is particularly important during a financial crisis) is liquidity. This refers to the capability to get out of investments. Lowering interest rates gives borrowers increased flexibility which prevents the market from breaking down.
Inflation and Investment
One of the most important questions for investors is “How will inflation impact my investments?” This issue can be particularly concerning for people (such as retirees) who have a fixed income. The way that your portfolio is affected by inflation will depend upon the securities that you hold. If your portfolio is comprised solely of stocks then you needn’t worry about inflation as the revenue of a company should increase in line with inflation rates. This will generally occur except for cases of stagflation where a bad economy combined with rising costs will have a negative impact on the value of stocks.
It is often useful to think of a company as being similar to a regular consumer. If it has a lot of cash reserves, then its purchasing power will decrease to a greater extent if the inflation rate increases. A problematic element of dealing with stocks is that companies tend to overstate their returns. This means that high inflation rates may create the perception that a company is prospering much more than it actually is. It is very important that you remember that the technique used by the company to value their inventory can have a major impact on the information presented in their financial statements.
As previously mentioned, increased inflation rates have the greatest impact on fixed-income earners.
EXAMPLE: Assume that you invested $2000 in a Treasury bill with an interest rate of 10%. A year later you would be able to collect $2200 that is owed to you. The 10% ($200) return that you made cannot be considered real due to the affect that inflation has on your purchasing power. Rising inflation means a reduction in purchasing power which, in turn, means a reduction in the actual value of your return. If the inflation rate for that year was 4% then the interest rate on the investment needs to be reduced by this amount, making it an actual interest rate of 6%. This situation illustrates the difference between a nominal and real interest rate. Nominal interest rate refers to the rate that your money grows (10% in the above example), whereas the real interest rate refers to the nominal rate minus the inflation rate (6% in the above example). It is important that investors look at the true value of the interest rates of their investments. Many investors make the mistake of only considering the nominal interest rate and forgetting about what this means in terms of purchasing power.
Some types of securities guarantee to investors that the return will not be reduced by inflation. One example is Treasury inflation-protected securities, commonly referred to as TIPS. TIPS are similar to other Treasury bonds except that they are linked to the CPI and will increase to compensate for rising inflation rates. While this may appear to be a good deal in theory; in reality, it is very rare that investors will look for an inflation protected investment. Inflation rates have been consistently low recently so it hasn’t been considered to be a big issue. Also, because these are such a safe investment option, the interest rates that they offer are so low that most investors are simply not interested.
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