What is Inflation, How It's Measured and Its Impact on Your Investments
What is Inflation?One of the most important economic concepts is inflation. At its most basic level, inflation is simply a rise in prices. Over time, as the cost of goods and services increase, the value of a dollar is going to go down because you won't be able to purchase as much with that dollar as you could have last month or last year.
It is important to note that some amount of inflation is considered normal (actually, as we explain below, because of its relationship with unemployment, some inflation is actually desirable). While the annual rate of inflation has fluctuated greatly over the last half century, ranging from nearly zero inflation to 23% inflation, the Fed actively tries to maintain a specific rate of inflation, which is usually 2-3% but can vary depending on circumstances.
Deflation (for example, -1%) occurs when prices actually decrease over a period of time. Please note that deflation is not the same as disinflation, which is when the rate of inflation decreases but stays positive (for example, a change from a 3% rate to a 2% rate).
How Inflation is MeasuredThere are two main indices used to measure inflation. The first is the Consumer Price Index, or the CPI . The CPI is a measure of the price of a set group of goods and services. The "bundle," as the group is known, contains items such as food, clothing, gasoline, and even computers. The amount of inflation is measured by the change in the cost of the bundle: if it costs 5% more to purchase the bundle than it did one year before, there has been a 5% annual rate of inflation over that period based on the CPI.
You will also often hear about the "Core CPI" or the "Core Rate." There are certain items in the bundle used to measure the CPI that are extremely volatile, such as gasoline prices. By eliminating the items that can significantly affect the cost of the bundle (in either direction) on a month-to-month basis, the Core rate is thought to be a better indicator of real inflation, the slow, but steady increase in the price of goods and services.
The second measure of inflation is the Producer Price Index, or the PPI . While the CPI indicates the change in the purchasing power of a consumer, the PPI measures the change in the purchasing power of the producers of those goods. The PPI measures how much producers of products are getting on the wholesale level, i.e. the price at which a good is sold to other businesses before the good is sold to a consumer. The PPI actually combines a series of smaller indices that cross many industries and measure the prices for three types of goods: crude, intermediate and finished. Generally, the markets are most concerned with the finished goods because these are a strong indicator of what will happen with future CPI reports. The CPI is a more popular measure of inflation than the PPI, but investors watch both closely .
Impact of Inflation
Inflation and Your InvestmentsInflation is greatly feared by investors because it grinds away at the value of your investments. Put simply, $100 today is not the same as $100 in 1 or 10 years. It is crucial to include measures of expected inflation when calculating your expected return on investment.
As the most basic example, if you invest $1000 in a 1-year CD that will return 5% over that year, you will be giving up $1000 right now for $1050 in 1 year. If over the course of that year there is an inflation rate of 6%, the purchasing power of $1000 has decreased by $60, and you have actually lost ground! (Of course, the capital gains taxes you pay on your "gain" will increase this loss.) If you had spent that $1000 instead of investing it, you would have been able to purchase a larger bundle of goods than was possible with the $1050 you earned a year later.
However, this is not a suggestion that you spend your money instead of saving it. First, the reasons to save are too numerous to list, but a home and retirement should be enough to inspire you. Given that savings are important, inflation eats away at your purchasing power more if you just put your savings under your mattress than if you had invested it.
Now that this issue has been clarified, it is important to be aware of the effects of inflation on your investments. Whenever you can, try to determine your "real rate of return", which is the return you can expect after factoring in the effects of inflation. If you are working with a financial professional, ask him or her for an estimate of the real rate of return of a given investment or portfolio.
As explained, inflation can erode the value of cash investments, such as stocks, bonds, and CDs. However, some people believe that investments in real goods, such as a home, are protected from inflation. This is because the value of a real good is determined to a large extent by its intrinsic nature, as opposed to money, which is valued only for what you can trade it for. If inflation is high, the price of a home or a car may simply increase at a similar rate, insulating it from price erosion. The same cannot be said for a 10-year bond. As a result, some investors seek protection from inflation, and investment options which do just that are becoming available. The most popular example is Treasury Inflation Protected Securities (or TIPS). These investments are just like bonds except that they are insulated from the effects of inflation .
The description above explains why investors follow CPI and PPI reports so closely. In addition to being aware of the current rate of inflation, it is crucial to be aware of what inflation rate the experts are anticipating. Both the value of current investments and the attractiveness of future investments will change depending on the outlook for inflation.
Inflation and UnemploymentMany modern economists believe that inflation is inversely related to unemployment. This relationship is shown through something called the Phillips Curve. The Phillips Curve shows the relationship between a given level of inflation and the expected level of unemployment that would go along with it. As inflation decreases, unemployment is expected to rise. This relationship is why you hear about the Fed's dual tasks of keeping inflation in check and maintaining full employment. Economists agree that there is a minimum level of unemployment that an economy can handle without causing inflation to accelerate .
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