Investors are likely to hear the terms inflation and gross domestic product (GDP) just about every day. They are often made to feel that these metrics must be studied as a surgeon would study a patient's chart prior to operating. Chances are that we have some concept of what they mean and how they interact, but what do we do when the best economic minds in the world can't agree on basic distinctions between how much the U.S. economy should grow, or how much inflation is too much for the financial markets to handle? Individual investors need to find a level of understanding that assists their decision-making without inundating them in piles of data. Find out what inflation and GDP mean for the market, the economy and your portfolio.

Terminology
Before we begin our journey into the macroeconomic village, let's review the terminology we'll be using.

Inflation
Inflation can mean either an increase in the money supply or an increase in price levels. Generally, when we hear about inflation, we are hearing about a rise in prices compared to some benchmark. If the money supply has been increased, this will usually manifest itself in higher price levels - it is simply a matter of time. For the sake of this discussion, we will consider inflation as measured by the core Consumer Price Index (CPI), which is the standard measurement of inflation used in the U.S. financial markets. Core CPI excludes food and energy from its formulas because these goods show more price volatility than the remainder of the CPI. (To read more on inflation, see All About Inflation, Curbing The Effects Of Inflation and The Forgotten Problem Of Inflation.)

GDP
Gross domestic product in the United States represents the total aggregate output of the U.S. economy. It is important to keep in mind that the GDP figures as reported to investors are already adjusted for inflation. In other words, if the gross GDP was calculated to be 6% higher than the previous year, but inflation measured 2% over the same period, GDP growth would be reported as 4%, or the net growth over the period. (To learn more about GDP, read Macroeconomic Analysis, Economic Indicators To Know and What is GDP and why is it so important?)

The Slippery Slope
The relationship between inflation and economic output (GDP) plays out like a very delicate dance. For stock market investors, annual growth in the GDP is vital. If overall economic output is declining or merely holding steady, most companies will not be able to increase their profits, which is the primary driver of stock performance. However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable. Most economists today agree that 2.5-3.5% GDP growth per year is the most that our economy can safely maintain without causing negative side effects. But where do these numbers come from? In order to answer that question, we need to bring a new variable, unemployment rate, into play. (For related reading, see Surveying The Employment Report.)

Studies have shown that over the past 20 years, annual GDP growth over 2.5% has caused a 0.5% drop in unemployment for every percentage point over 2.5%. It sounds like the perfect way to kill two birds with one stone - increase overall growth while lowering the unemployment rate, right? Unfortunately, however, this positive relationship starts to break down when employment gets very low, or near full employment. Extremely low unemployment rates have proved to be more costly than valuable, because an economy operating at near full employment will cause two important things to happen:

  1. Aggregate demand for goods and services will increase faster than supply, causing prices to rise.
  2. Companies will have to raise wages as a result of the tight labor market. This increase usually is passed on to consumers in the form of higher prices as the company looks to maximize profits. (To read more, see Cost-Push Versus Demand-Pull Inflation.)

Over time, the growth in GDP causes inflation, and inflation begets hyperinflation. Once this process is in place, it can quickly become a self-reinforcing feedback loop. This is because in a world where inflation is increasing, people will spend more money because they know that it will be less valuable in the future. This causes further increases in GDP in the short term, bringing about further price increases. Also, the effects of inflation are not linear; 10% inflation is much more than twice as harmful as 5% inflation. These are lessons that most advanced economies have learned through experience; in the U.S., you only need to go back about 30 years to find a prolonged period of high inflation, which was only remedied by going through a painful period of high unemployment and lost production as potential capacity sat idle.

"Say When"
So how much inflation is "too much"? Asking this question uncovers another big debate, one argued not only in the U.S,. but around the world by central bankers and economists alike. There are those who insist that advanced economies should aim to have 0% inflation, or in other words, stable prices. The general consensus, however, is that a little inflation is actually a good thing.

The biggest reason behind this argument in favor of inflation is the case of wages. In a healthy economy, sometimes market forces will require that companies reduce real wages, or wages after inflation. In a theoretical world, a 2% wage increase during a year with 4% inflation has the same net effect to the worker as a 2% wage reduction in periods of zero inflation. But out in the real world, nominal (actual dollar) wage cuts rarely occur because workers tend to refuse to accept wage cuts at any time. This is the primary reason that most economists today (including those in charge of U.S. monetary policy) agree that a small amount of inflation, about 1-2% a year, is more beneficial than detrimental to the economy.

The Federal Reserve and Monetary Policy
The U.S. essentially has two weapons in its arsenal to help guide the economy toward a path of stable growth without excessive inflation; monetary policy and fiscal policy. Fiscal policy comes from the government in the form of taxation and federal budgeting policies. While fiscal policy can be very effective in specific cases to spur growth in the economy, most market watchers look to monetary policy to do most of the heavy lifting in keeping the economy in a stable growth pattern. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) is charged with implementing monetary policy, which is defined as any action to limit or increase the amount of money that is circulating in the economy. Whittled down, that means the Federal Reserve (the Fed) can make money easier or harder to come by, thereby encouraging spending to spur the economy and constricting access to capital when growth rates are reaching what are deemed unsustainable levels.

Before he retired, Alan Greenspan was often (half seriously) referred to as being the most powerful person on the planet. Where did this impression come from? Most likely it was because Mr. Greenspan's position (now Ben Bernanke's) as Chairman of the Federal Reserve provided him with special, albeit un-sexy, powers - chiefly the ability to set the Federal Funds Rate. The "Fed Funds" rate is the rock-bottom rate at which money can change hands between financial institutions in the United States. While it takes time to work the effects of a change in the Fed Funds rate (or discount rate) throughout the economy, it has proved very effective in making adjustments to the overall money supply when needed. (To continue reading about the Fed, see Formulating Monetary Policy, The Federal Reserve and A Farewell To Alan Greenspan.)

Asking the small group of men and women of the FOMC, who sit around a table a few times a year, to alter the course of the world's largest economy is a tall order. It's like trying to steer a ship the size of Texas across the Pacific - it can be done, but the rudder on this ship must be small so as to cause the least disruption to the water around it. Only by applying small opposing pressures or releasing a little pressure when needed can the Fed calmly guide the economy along the safest and least costly path to stable growth. The three areas of the economy that the Fed watches most diligently are GDP, unemployment and inflation. Most of the data they have to work with is old data, so an understanding of trends is very important. At its best, the Fed is hoping to always be ahead of the curve, anticipating what is around the corner tomorrow so it can be maneuvered around today.

The Devil Is in the Details
There is as much debate over how to calculate GDP and inflation as there is about what to do with them when they're published. Analysts and economists alike will often start picking apart the GDP figure or discounting the inflation figure by some amount, especially when it suits their position on the markets at that time. Once we take into account hedonic adjustments for "quality improvements", reweighting and seasonality adjustments, there isn't much left that hasn't been factored, smoothed, or weighted in one way or another. Still, there is a methodology being used, and as long as no fundamental changes to it are made, we can look at rates of change in the CPI (as measured by inflation) and know that we are comparing from a consistent base.

Implications for Investors
Keeping a close eye on inflation is most important for fixed-income investors, as future income streams must be discounted by inflation to determine how much value today' money will have in the future. For stock investors, inflation, whether real or anticipated, is what motivates us to take on the increased risk of investing in the stock market, in the hope of generating the highest real rates of return. Real returns (all of our stock market discussions should be pared down to this ultimate metric) are the returns on investment that are left standing after commissions, taxes, inflation and all other frictional costs are taken into account. As long as inflation is moderate, the stock market provides the best chances for this compared to fixed income and cash.

There are times when it is most helpful to simply take the inflation and GDP numbers at face value and move on; after all, there are many things that demand our attention as investors. However, it is valuable to re-expose ourselves to the underlying theories behind the numbers from time to time so that we can put our potential for investment returns into the proper perspective.

Related Articles
  1. Economics

    Industries That Thrive On Recession

    Recessions are not equally hard on everyone. In fact, there are some industries that even flourish amid the adversity.
  2. Investing News

    What's the Fed Going to do in 2016?

    Learn about the factors that contribute to increases in the federal funds rate by the Federal Reserve and key economic indicators for 2016.
  3. Economics

    Will Silver Recover in 2016? (SLV, GLD, JJC)

    The end of the silver downtrend is likely to coincide with similar recoveries in gold, iron and copper.
  4. Forex

    The Consumer Price Index

    Find out how this economic measure can help you make key financial decisions.
  5. Economics

    Understanding the History of Money

    Money has been a part of human history for at least 3,000 years, evolving from bartering to banknotes.
  6. Economics

    Explaining Economic Indicators

    Investors use economic indicators to gauge investment opportunities and judge the overall health of an economy.
  7. Economics

    How Interest Rates Affect The U.S. Markets

    When indicators rise more than 3% a year, the Fed raises the federal funds rate to keep inflation under control.
  8. Economics

    Forces Behind Interest Rates

    Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.
  9. Markets

    The (Expected) Market Impact of the 2016 Election

    With primary season upon us, investor attention is beginning to turn to the upcoming U.S. presidential election.
  10. Investing News

    Global Headwinds Hit the 6 Biggest Economies

    As of Friday, initial estimates for fourth-quarter and full-year 2015 growth in gross domestic product (GDP) are available for five of the world's six largest national economies, and for the ...
RELATED FAQS
  1. What is the relationship between nominal GDP and PPP (purchasing power parity)?

    Gross domestic product (GDP) represents an accounting of the total value of all final goods and services produced in a geographic ... Read Full Answer >>
  2. How does the United States government measure economic growth?

    The most widespread measurement of national economic growth is gross domestic product, or GDP. The U.S. government collects ... Read Full Answer >>
  3. What are the nations with the highest PPP (purchasing power parity) with respect ...

    Gross domestic product (GDP) is the total dollar value of all goods and services produced by a country in a given year. It ... Read Full Answer >>
  4. What is comparative advantage?

    Comparative advantage is an economic law that demonstrates the ways in which protectionism (mercantilism, at the time it ... Read Full Answer >>
  5. How does the Wall Street Journal prime rate forecast work?

    The prime rate forecast is also known as the consensus prime rate, or the average prime rate defined by the Wall Street Journal ... Read Full Answer >>
  6. What is a basis point (BPS)?

    A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center