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Level 5 Economics - Inflation

In the 1930s, you could buy a loaf of bread for $0.15, a new car for less than $1,000 and an average house for around $5,000. In the twenty-first century, all of these things, and just about everything else in the world cost a whole lot more. It's pretty obvious that inflation has had a major affect on how far our money goes over the last 60 years.

When inflation surged to double-digit levels in the mid- to late-1970s, Americans saw it as the American economy's greatest threat. Since then, public anxiety has abated along with the inflation rate, but people remain fearful of inflation, even at the tepid levels we've seen in the past few years. Although it's common knowledge that prices go up over time, the general population doesn't understand the forces behind inflation, and surprisingly, very few forex traders do either.

What causes inflation? How does it affect your standard of living? What does inflation mean for a nation's currency? Let's take a closer look.

The value of a dollar does not stay constant when there is inflation. The value of a dollar is observed in terms of purchasing power, which is the real, tangible goods that your money can buy. When inflation rises, your purchasing power falls. For example, if the inflation rate is 2% annually, then theoretically a $1 pack of gum should cost $1.02 next year. After inflation, your dollar can't buy the same goods it could beforehand.

There are several variations on inflation:

  • Deflation is when the general level of prices is falling. This is the opposite of inflation.
  • Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system.
  • Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices.

In recent years, most developed countries have attempted to sustain an inflation rate of around 2-3%.

Causes of Inflation
Although the causes of inflation are greatly debated, there are at least two theories that are generally accepted:

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 business' 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.

Costs of Inflation
Inflation has a bad rap, but it's really just misunderstood. Inflation affects different people in different ways. A major factor in how inflation is viewed is whether inflation is anticipated or unanticipated. If the inflation rate is in line with what the majority of people are expecting (anticipated inflation), then we can compensate and the cost isn't high. For example, banks can vary their interest rates and Businesses can price their products accordingly. (to learn more, see The Importance Of Inflation And GDP.)

Problems come up when there is unanticipated inflation:

  • Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For borrowers, this can sometimes equate to an interest-free loan.
  • Economics uncertainty can lead to consumers and corporations spending less hurting 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, and the domestic currency usually depreciates.

Inflation is a sign that an economy is growing however. In some situations, little inflation (or even deflation) can be just as bad as high inflation. A 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 - it depends on the overall economy as well as what side of the coin you're on.
Measuring inflation is a difficult problem for government statisticians as well. To do this, a number of goods that are representative of the economy are put together into what is commonly referred to as a "market basket." The cost of this basket is then compared over time. inform these comparisons we get 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.

In
North America, there are two major price indexes that measure inflation:

  • Consumer Price Index (CPI) - A measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective of the purchaser. U.S. CPI data can be found at the Bureau of Labor Statistics.
  • Producer Price Indexes (PPI) - A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. U.S. PPI data can be found at the Bureau of Labor Statistics.

It may be easier to think of these price indexes as large surveys. Every month, the U.S. Bureau of Labor Statistics contacts thousands of retail stores, service establishments, rental units and profesional offices to acquire price information on thousands of items used to track and measure price changes in the CPI. They record the prices of about 80,000 items each month, which represent a scientifically selected sample of the prices paid by consumers for the goods and services purchased.

In the long run, the various PPIs and the CPI should show a similar rate of inflation. This is not the case in the short run however, as PPIs will almost always increase before the CPI. In general, investors and traders follow the CPI more than the PPIs.

Contrary to popular belief, excessive economic growth can in fact be very detrimental to the economy. At one extreme, an economy that is growing too quickly can experience hyperinflation, resulting in the problems we touched on earlier. At the other extreme, an economy with no inflation will essentially stagnate. The right level of economic growth, and thus inflation, lies somewhere in the middle.

The impact of inflation on a stock portfolio is marginal. Over the long run, a company's revenue and earnings should increase at the same pace as inflation. The exception to this of course is stagflation. The combination of a weak economy with an increase in costs is awful for stocks. In this situation a company is in the same situation as a normal consumer - the more cash it carries, the more its purchasing power decreases with increases in inflation.

The primary 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 performing extremely well, when in actuality, 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. (For more, see Inventory Valuation For Investors: FIFO And LIFO.)

Fixed-income investors are the hardest hit by inflation. For example, if a year ago you invested $1,000 in a Treasury bill with a 10% yield. Now that you are about to collect the $1,100 owed to you, is your $100 (10%) return real? You wish! Assuming inflation was positive for the year, your purchasing power will have fallen and, as a result, so has your real return. We have to take into account the portion inflation has taken out of your return. If inflation was 4%, then your return is actually only 6%.

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. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. In our example, the nominal rate is 10% and the real rate is 6% (10% - 4% = 6%).

As a forex trader however, inflation is of key importance to your trading decisions. Countries with high inflation generally will have a currency that performs weaker than its peers. Keeping a close eye on inflation numbers will help you make smart trades. Be aware however that inflation is an art rather than a science, and inflation's relationship with currency value is not concrete. As we've previously discussed, inflation should be considered as just one of several economic indicators when making trading decisions for any given currency.(To learn more, check out Fight Back Against Inflation.)

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