What It Is:
Inflation is the rate at which prices rise and purchasing power falls. It is why something that cost $1 in 1980 cost $2.37 in 2005.
How It Works/Example:
Two general theories explain inflation. The first, the demand-pull theory, says that prices increase when demand for goods and services exceeds their supply. The second, the cost-push theory, says that companies create inflation when they raise their prices to cover higher supply prices and maintain profit margins.
The Bureau of Labor Statistics (BLS) calculates and publishes the Consumer Price Index(CPI), which is the most recognized inflation measure in the United States, each month. The CPI measures the change in the retail prices of approximately 80,000 specific goods and services, called the market basket. An example of a specific good could be a 4.4-pound bag of "extra-fancy" grade Golden Delicious apples. The goods and services fall into eight major categories: food and beverage, housing, apparel, transportation, medical care, recreation, education and communication, and other. The BLS updates the market basket every few years to remove obsolete items; the last update occurred during 2001 and 2002.
The BLS calculates the CPI by comparing the cost of the market basket to the same basket in the starting year (usually 1982-1984). To do this, the BLS sets the average price of the market basket during the years 1982, 1983, and 1984 to equal 100. Then in every subsequent period, the BLS calculates price changes in relation to that number. A CPI of 120, for example, means that prices are 20% higher than they were in the base period.
There is more than one CPI measure. The most common, the Consumer Price Index for All Urban Consumers (CPI-U), measures prices in urban areas, where much of the American population resides. The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) and the CPI for Urban Wage Earners and Clerical Workers (CPI-W), also measure inflation, but do so using different assumptions (in the case of the C-CPI-U, it accounts for certain consumer behaviors such as substituting items) or only with certain types of households.
Just as there is more than one CPI measurement, there are several different measurements for inflation. The Producer Price Index (PPI), for example, is a popular inflation measure that measures the average change in wholesale prices. PPI often increases before CPI, and this is somewhat of a leading inflation indicator. Other measures include the Employment Cost Index(Employment Cost Index), which measures inflation in the labor market; the BLS International Price Program, which measures inflation in import and export prices; and the Gross Domestic Product Deflator (GDP Deflator), which combines prices to consumers, producers, and the government.
Inflation has a significant effect on investment returns and decisions. For example, let's assume that you invest $1,000 in a one-year XYZ Company bond. If the bond yields 5%, then at the end of the year you will collect $1,050. Your 5% return may not be as good as it looks if the inflation rate was 4% during the year. Your real return is actually 1%. Some securities, such as Treasury Inflation-Protected Securities (TIPS), tie their principal and coupon payments to the CPI in order to compensate the investor for inflation. The Chicago Mercantile Exchange also trades futures contracts on the CPI. These can be used to hedge inflation, and they indicate the market's opinion about future prices.
Why It Matters:
Inflation's fundamental relationship with supply and demand means that inflation directly or indirectly affects nearly every financial decision, from consumer choices to lending rates, and from asset allocation to stock prices. The inflation rate also offers important clues about the state of an economy. Most economists agree that moderate inflation is a sign of a growing economy and that deflation is a sign of stagnation.
When inflation is high, overall prices are rising within the economy. In this type of environment, businesses generally have little trouble raising prices to their customers. What's more, there's a certain momentum to inflation data; when consumers see inflation they usually expect prices to rise. That makes it easier for businesses to justify price hikes. However, when inflation is fairly low, it makes it extremely difficult for most companies to raise prices for goods and services. Furthermore, inflation can influence the following areas:
Inflation can distort a company's financial performance. For example, a company that reports high revenue growth during a period of rising inflation could be misleading shareholders if those revenues were the result of inflationary pressure rather than managerial skill. For this reason, many analysts use inflation information to "deflate" or adjust certain financial measures so that they can compare them accurately over time. Inflation can also influence a company's choices in accounting methods.
Although all of the factors above can affect a company's stock price, perhaps the largest effect inflation has on securities is found in the discount rate. When inflation is high or rising, the future dividends or interest payments from an investment are worth less. In broad terms, the higher inflation goes, the higher the discount rate goes, and the lower the value of the security goes. The reverse is also true.
Because the Federal Reserve's job is to maintain long-term economic prosperity through the execution of monetary policy, it takes a keen interest in inflation rates when deciding whether to raise or lower the buyout. This is one reason some analysts consider inflation a measure of the effectiveness of certain government policies.
Contracts and Obligations
Contracts and other obligations involving payments over time often consider inflation. For example, many labor contracts tie wage adjustments to changes in the CPI, as do some alimony, child support, rent, royalty, and other obligations affected by changes in purchasing power. People living off fixed incomes are particularly affected by inflation, and this is why the government usually adjusts Social Security checks and food stamps, as well as the wages of federal employees and members of the military on a regular basis.
For more information about the Bureau of Labor Statistics inflation measures, visit www.bls.gov/cpi.