What Is The Importance Of Inflation And It’s Implications
Hearing about Gross Domestic Product (GDP) and Inflation is an everyday occurrence for most investors, and they approach these metrics with the precision of a physician about to operate on a very delicate patient. For the average person, these terms are vaguely comprehensible, and we might even have a slight idea of how they relate to each other, but the challenge comes when economics experts struggle to agree on how much to increase inflation, how much the national economy should grow and so on. Click Here To Go Straight To Our Online Tutorial
As an individual investor, it’s imperative that you understand these terms in a way that enables you to make better investment choices and plowing through too much data doesn’t help with that process in the least. Read on to find out what the implications of GDP and inflation are for the market, and how all of this affects your investment portfolio as well as the overall economy.
First, let’s start by getting an understanding of the terminology that you’ll come across throughout this article:
Inflation typically refers to either a spike in prices or the supply of money circulating in the economy. Whenever economists talk about inflation, it’s always about price increases that happen in association with a particular benchmark. Prices tend to increase as soon as the supply of money goes up as well. For this article, we’ll be using the core Consumer Price Index (CPI) as a yardstick to measure inflation, as the CPI is the benchmark often utilized by U.S. financial markets. Keep in mind that core CPI does not include energy and food due to the volatility of these goods when compared to other aspects of the CPI.
In the U.S., gross domestic product signifies the combined economic output of the country. Investors typically get the revised version of the GDP, based on current inflation levels. This means that if for example, economists calculate the GDP to be 6% higher than the year before, while inflation only increased by 2%, then the net GDP growth will be reported as 4% for that year.
The Slippery Slope
The correlation between GDP and inflation is a very delicate one, and these two variables interact in mysterious ways. Yearly GDP growth is essential to investors in the stock market. As total economic output gets well-balanced or starts to decline for whatever reason, a lot of companies suffer as they’re unable to raise their profits, which in turn affects the performance of their stock. On the other hand, unbridled growth of the GDP can be quite hazardous, as it inevitably leads to inflation, which devalues the currency (and prospective corporate revenue) and eats into stock market growth. If there’s one thing that modern economists can agree on, it’s the fact that the safe margin for GDP growth is usually between 2.5-3.5%. However, that begs the question; how did they come up with those figures? To effectively answer that question, we would have to take the unemployment rate into consideration.
According to research done over the past two decades, whenever the GDP growth goes beyond the 2.5% mark, it is almost always accompanied by a 0.5% decrease in the unemployment rate. On paper, it seems like the ideal way to multitask, and all you have to do is increase economic growth, and your unemployment levels will go down too. Paradoxically, the problem comes when the unemployment rate starts approaching near extinction. Getting rid of unemployment can do more damage than good because it typically leads to two of the following occurrences:
- The prices of goods will increase as a result of an imbalance between the demand for goods and services vis a vis the supply of those goods and services.
- As the labor market tightens, companies are forced to increase wages. Consumers will then feel the pinch as well because companies will have to increase prices in a bid to maximize returns.
Gradually, GDP growth leads to inflation and that inflation inevitably becomes hyperinflation. As you can imagine, what results is a self-replicating feedback loop that goes on and on. This typically occurs because as the inflation rate continues to rise, consumers begin to spend recklessly with the understanding that money will lose a significant amount of value shortly. This leads to a further short-term GDP growth which escalates prices even more. Plus, keeping in mind that inflation effects are circular, it is safe to assume that 5% inflation is safer than 10% inflation. Most of the advanced countries have had to learn this economic lesson the hard way. In fact, go back just three decades in U.S. history, and you’ll find that the country has experienced high inflation for sustained periods of time, which could only be alleviated by an excruciating era of extremely high unemployment and production losses due to the loss in potential capacity.
How Much Inflation is “Too Much”?
For the longest time, this question has been the cause of unending debate between economists and central bankers all over the world. On the one hand, there is a school of thought which believes that advanced nations with healthy economies should aspire to 0% inflation while still being able to maintain price stability. However, the consensus is that inflation in small doses is a healthy part of any economy.
Those in favor of inflation cite wages as the motivation behind their argument. The thing is, a robust economy will typically experience market forces that put pressure on companies to reduce actual wages after inflation. Theoretically speaking, increasing wages by 2% annually while inflation increases by 4% pretty much lead to the same result as getting a 2% reduction in wages during a year of zero inflation.
However, on a more practical level, it’s rare to find real wage cuts because most workers would simply not have it! That’s why economists advise that inflation is a healthy part of the economy, albeit in small doses of 1% to 2%, and even the economists leading the U.S. monetary policy agree on this.
The Federal Reserve and Monetary Policy
There are two roads that the U.S. can choose to be trodden to realize growth stability without the occurrence of extreme inflation, and those two roads are fiscal policy and monetary policy. Fiscal policy is developed by the government and comes in the form of federal budgeting policies as well as taxes. Most of the time, fiscal policy can be a very useful tool when it comes to promoting economic growth, and market analysts consider it to be the most effective tool at achieving stable market growth over time. The Federal Reserve Board’s Open Market Committee (FOMC) of the U.S. is tasked with a responsibility to execute monetary policy, which basically refers to the act of increasing or decreasing the flow of money within the economy. This means that the Federal Reserve can increase accessibility to money, and in so doing promote overall spending to stimulate the economy. The Fed can also choose to tighten access to capital whenever economic growth reaches levels that are considered unsustainable.
Before his retirement, Alan Greenspan was frequently referred to as the most powerful man on the planet due to his position as Chairman of the Federal Reserve, a position which now belongs to Ben Bernanke. Why is this so? Well, as Chairman of the Fed, one has the power to set the Federal Funds Rate, and if you’re wondering what the Fed Funds rate refers to, it simply means the lowest rate that financial institutions can use to exchange money. Granted, it takes a while before the influence of the Fed Funds rate is evident on the economy, but when used right, it can be a very effective technique to use to gently adjust the flow of money in the economy when necessary.
Of course, it is no small feat for the group of men and women in the FOMC, to make decisions that they know will affect the largest economy in the world. This mammoth task can be likened to steering a large ship across the Pacific. Sure, it can be done, but a small rudder must be used to minimize disruption as much as possible. Similarly, the Fed applies or releases only a little bit of opposing pressure and only when necessary to steer the country’s economy in the right direction, using the most cost-effective and safest methods possible. This is why it’s so important for the Fed to watch three specific economic factors closely, and that is the unemployment rate, the GDP, and inflation. Of course, they have to use dated data to do their work because that helps them to understand better trends, which is very important. However, the goal of the Fed is to stay ahead of the game and anticipate future scenarios to outmaneuver whatever’s to come.
The Devil is in the Details
There is a lot of ongoing discussion about how GDP and inflation should be calculated, as there is about how to combat it when it is established and published. The first thing that economists and analysts will do when inflation and GDP figures are published is to pick apart at them to discount the inflation numbers so that they suit their market position. Afterward, we have to consider adjustments due to factors like seasonality and reweighting, not to mention wanton adjustments in the name of “quality improvements.” However, there is a method to the madness, because as long as the changes aren’t fundamental, we can easily spot rate adjustments in the CPI according to inflation, and still have confidence that we’re using a steady base to make our comparison.
Inflation and Asset Classes
You will find that liquid assets are affected in the same way by inflation as other asset types, with the only exception being liquid assets, whose value generally appreciates at a reduced pace over time.
What this means is that net liquid assets are generally susceptible to the negative effects of inflation. When looked at from the perspective of the overall economy, this means that higher inflation rates prohibit businesses and individuals from holding a large number of liquid assets.
This is not to say that illiquid assets do not get influenced by inflation, but they do possess an organic defense if their value increases or if they generate interest. One of the main reasons why employees invest their money in stocks, mutual funds and bonds are to protect their life savings from the negative effects of inflation. You see, when inflation increases to a certain point, investors tend to exchange their liquid assets from interest-generating assets, or they will solidify their liquid assets by purchasing consumer goods.
Therefore, the best way to maintain your purchasing power while keeping your investment safe is to diversify your investment across several inflation-protected securities, like Treasury inflation-protected securities (TIPS) and inflation-indexed bonds. The good thing about these investments is that they change along with inflation, which renders them invulnerable to inflation risk.
Implications for Investors
Fixed-income investors stand to benefit the most from observing inflation, as it will affect future income streams while deciding on the present and future value of their money. Stock investors take inflation as motivation to invest even more in the stock market, whether that inflation risk is real or anticipated because there is always a possibility of generating higher returns. Real returns, as in real dollars and cents, are the returns on investments that you have after you’ve taken away taxes, commissions, inflation as well as additional frictional costs. When inflation is kept at an even keel, you can bet that there will be a better chance of getting higher returns – all things considered- when compared to cash or fixed income.
Keeping in mind the number of balls that investors need to have in the air at all times, simplicity is sometimes the best policy, and this means taking GDP and inflation numbers as they are. On the other hand, it is also good to understand the theory -the method behind the madness- to put everything into perspective and hopefully improve your ROI potential as an investor.