Inflation
Inflation refers to a general increase in the price of goods and services. This occurs when demand for these items grows faster than the supply. The result is more money chasing fewer goods, and therefore prices increase. Ensuring that your client's investments outpace the rate of inflation over the long haul is one of the major challenges for an IA.

The most important measure of inflation is the Consumer Price Index (CPI). The stock and bond markets are very sensitive to changes in the CPI because when inflation rises, purchasing power is eroded. The ensuing drop in consumer spending has a negative effect on stock and bond prices.

For more on the CPI, such as how it is constructed, its uses, and how it can be used to protect against inflation, refer to Why the CPI Is a Friend to Investors.

The rate of inflation tends to increase during economic expansions and decrease during recessions. Inflation tends to be moderate during expansions, and high inflation rates tend to hasten the transition from peak to recession. Deflation is rare and occurs only during recessions.

What causes inflation? How does it affect your investments and standard of living? The tutorial All About Inflation has the answers.


Deflation
Deflation is a general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can also be caused by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.

Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve (the Fed) can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and take some of the depressive pressures off wages and debtors of every kind.

This is the opposite of inflation, which is characterized by rising prices (do not confuse deflation with disinflation, which is simply a slowing of inflation). To many economists, deflation is more serious than inflation because deflation is more difficult to control.

Equity prices begin to decline as people sell off their investments, which are no longer offering good returns, and bonds temporarily become more attractive.

Stagflation
This is a condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or inflation.

Stagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects.
Yield Curve

Related Articles
  1. Insights

    What's The Difference Between Inflation And Deflation?

    Inflation occurs when the prices of goods and services rise. Deflation occurs when prices decrease.
  2. Insights

    Should You Worry About the U.S Inflation rate?

    Understand how inflation is measured, how U.S. inflation compares to other countries, and if investors should be concerned with rising inflation.
  3. Insights

    Why is Deflation Bad for the Economy?

    Deflation can adversely affect the economy in significant ways.
  4. Insights

    Can Deflation Be Good?

    General economic theory consensus rules that deflation is bad for the economy. But the Swiss economy, which is growing despite a drop in prices for the last four years, is proving otherwise. ...
  5. Insights

    Inflation's Impact on Stock Returns

    When stocks are divided into growth and value categories, the evidence is clear that value stocks perform better in periods of high inflation, and growth stocks perform better during periods ...
  6. Insights

    The Dangers Of Deflation

    We look at what life would be like in a deflationary environment, and what you can do to protect your investments.
  7. Insights

    9 Common Effects of Inflation

    Is inflation ever good? Maybe if you like your job it is.
  8. Trading

    Coping With Inflation Risk

    Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.
  9. Investing

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
Frequently Asked Questions
  1. Why Do Most of My Mortgage Payments Start Out as Interest?

    Fear not: Over the life of the mortgage, the portions of interest to principal will change.
  2. What is the difference between secured and unsecured debts?

    The differences between secured and unsecured debt, and how banks buffer risks associated with each type of loan through ...
  3. How Many Times has Warren Buffett Been Married?

    Warren Buffett has been married twice in his life, but the circumstances surrounding the marriages were unconventional.
  4. What's the smallest number of shares of stock that I can buy?

    Many people would say the smallest number of shares an investor can purchase is one, but the real answer is not as straightforward. ...
Trading Center