💾 Archived View for gmi.noulin.net › mobileNews › 3909.gmi captured on 2021-12-03 at 14:04:38. Gemini links have been rewritten to link to archived content
-=-=-=-=-=-=-
August 06 2011 | Filed Under Economics , Investing Basics
Inflation is defined as a sustained increase in the general level of prices for
goods and services. It is measured as an annual percentage increase as reported
in the Consumer Price Index (CPI), generally prepared on a monthly basis by the
U.S. Bureau of Labor Statistics. As inflation rises, purchasing power
decreases, fixed-asset values are affected, companies adjust their pricing of
goods and services, financial markets react and there is an impact on the
composition of investment portfolios.
Tutorial: All About Inflation
Inflation, to one degree or another, is a fact of life. Consumers, businesses
and investors are impacted by any upward trend in prices. In this article,
we'll look at various elements in the investing process affected by inflation
and show you what you need to be aware of.
Financial Reporting and Changing Prices
Back in the period from 1979 to 1986, the Financial Accounting Standards Board
(FASB) experimented with "inflation accounting," which required that companies
include supplemental constant dollar and current cost accounting information
(unaudited) in their annual reports. The guidelines for this approach were laid
out in Statement of Financial Accounting Standards No. 33, which contended that
"inflation causes historical cost financial statements to show illusionary
profits and mask erosion of capital."
With little fanfare or protest, SFAS No. 33 was quietly rescinded in 1986.
Nevertheless, serious investors should have a reasonable understanding of how
changing prices can affect financial statements, market environments and
investment returns.
Corporate Financial Statements
In a balance sheet, fixed assets - property, plant and equipment - are valued
at their purchase prices (historical cost), which may be significantly
understated compared to the assets' present day market values. It's difficult
to generalize, but for some firms, this historical/current cost differential
could be added to a company's assets, which would boost the company's equity
position and improve its debt/equity ratio.
In terms of accounting policies, firms using the last-in, first-out (LIFO)
inventory cost valuation are more closely matching costs and prices in an
inflationary environment. Without going into all the accounting intricacies,
LIFO understates inventory value, overstates the cost of sales, and therefore
lowers reported earnings. Financial analysts tend to like the understated or
conservative impact on a company's financial position and earnings that are
generated by the application of LIFO valuations as opposed to other methods
such as first-in, first-out (FIFO) and average cost. (To learn more, read
Inventory Valuation For Investors: FIFO And LIFO.)
Market Sentiment
Every month, the U.S. Department of Commerce's Bureau of Labor Statistics
reports on two key inflation indicators: the Consumer Price Index (CPI) and the
Producer Price Index (PPI). These indexes are the two most important
measurements of retail and wholesale inflation, respectively. They are closely
watched by financial analysts and receive a lot of media attention.
The CPI and PPI releases can move markets in either direction. Investors do not
seem to mind an upward movement (low or moderating inflation reported) but get
very worried when the market drops (high or accelerating inflation reported).
The important thing to remember about this data is that it is the trend of both
indicators over an extended period of time that is more relevant to investors
than any single release. Investors are advised to digest this information
slowly and not to overreact to the movements of the market. (To learn more,
read The Consumer Price Index: A Friend To Investors.)
Interest Rates
One of the most reported issues in the financial press is what the Federal
Reserve does with interest rates. The periodic meetings of the Federal Open
Market Committee (FOMC) are a major news event in the investment community. The
FOMC uses the federal funds target rate as one of its principal tools for
managing inflation and the pace of economic growth. If inflationary pressures
are building and economic growth is accelerating, the Fed will raise the
fed-funds target rate to increase the cost of borrowing and slow down the
economy. If the opposite occurs, the Fed will push its target rate lower. (To
learn more, read The Federal Reserve.)
All of this makes sense to economists, but the stock market is much happier
with a low interest rate environment than a high one, which translates into a
low to moderate inflationary outlook. A so-called "Goldilocks" - not too high,
not too low - inflation rate provides the best of times for stock investors.
Future Purchasing Power
It is generally assumed that stocks, because companies can raise their prices
for goods and services, are a better hedge against inflation than fixed-income
investments. For bond investors, inflation, whatever its level, eats away at
their principal and reduces future purchasing power. Inflation has been fairly
tame in recent history; however, it's doubtful that investors can take this
circumstance for granted. It would be prudent for even the most conservative
investors to maintain a reasonable level of equities in their portfolios to
protect themselves against the erosive effects of inflation. (For related
reading, see Curbing The Effects Of Inflation.)
Conclusion
Inflation will always be with us; it's an economic fact of life. It is not
intrinsically good or bad, but it certainly does impact the investing
environment. Investors need to understand the impacts of inflation and
structure their portfolios accordingly. One thing is clear: depending on
personal circumstances, investors need to maintain a blend of equity and
fixed-income investments with adequate real returns to address inflationary
issues.
by Richard Loth