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2012-03-19 12:03:25
August 13 2010 | Filed Under Economics , Economy , Interest Rates
Investors are likely to hear the terms inflation and gross domestic product
(GDP) just about every day. They are often made to feel that these metrics must
be studied as a surgeon would study a patient's chart prior to operating.
Chances are that we have some concept of what they mean and how they interact,
but what do we do when the best economic minds in the world can't agree on
basic distinctions between how much the U.S. economy should grow, or how much
inflation is too much for the financial markets to handle? Individual investors
need to find a level of understanding that assists their decision-making
without inundating them in piles of data. Find out what inflation and GDP mean
for the market, the economy and your portfolio.
Terminology
Before we begin our journey into the macroeconomic village, let's review the
terminology we'll be using.
Inflation
Inflation can mean either an increase in the money supply or an increase in
price levels. Generally, when we hear about inflation, we are hearing about a
rise in prices compared to some benchmark. If the money supply has been
increased, this will usually manifest itself in higher price levels - it is
simply a matter of time. For the sake of this discussion, we will consider
inflation as measured by the core Consumer Price Index (CPI), which is the
standard measurement of inflation used in the U.S. financial markets. Core CPI
excludes food and energy from its formulas because these goods show more price
volatility than the remainder of the CPI. (To read more on inflation, see All
About Inflation, Curbing The Effects Of Inflation and The Forgotten Problem Of
Inflation.)
GDP
Gross domestic product in the United States represents the total aggregate
output of the U.S. economy. It is important to keep in mind that the GDP
figures as reported to investors are already adjusted for inflation. In other
words, if the gross GDP was calculated to be 6% higher than the previous year,
but inflation measured 2% over the same period, GDP growth would be reported as
4%, or the net growth over the period. (To learn more about GDP, read
Macroeconomic Analysis, Economic Indicators To Know and What is GDP and why is
it so important?)
The Slippery Slope
The relationship between inflation and economic output (GDP) plays out like a
very delicate dance. For stock market investors, annual growth in the GDP is
vital. If overall economic output is declining or merely holding steady, most
companies will not be able to increase their profits, which is the primary
driver of stock performance. However, too much GDP growth is also dangerous, as
it will most likely come with an increase in inflation, which erodes stock
market gains by making our money (and future corporate profits) less valuable.
Most economists today agree that 2.5-3.5% GDP growth per year is the most that
our economy can safely maintain without causing negative side effects. But
where do these numbers come from? In order to answer that question, we need to
bring a new variable, unemployment rate, into play. (For related reading, see
Surveying The Employment Report.)
Studies have shown that over the past 20 years, annual GDP growth over 2.5% has
caused a 0.5% drop in unemployment for every percentage point over 2.5%. It
sounds like the perfect way to kill two birds with one stone - increase overall
growth while lowering the unemployment rate, right? Unfortunately, however,
this positive relationship starts to break down when employment gets very low,
or near full employment. Extremely low unemployment rates have proved to be
more costly than valuable, because an economy operating at near full employment
will cause two important things to happen:
Aggregate demand for goods and services will increase faster than supply,
causing prices to rise.
Companies will have to raise wages as a result of the tight labor market. This
increase usually is passed on to consumers in the form of higher prices as the
company looks to maximize profits. (To read more, see Cost-Push Versus
Demand-Pull Inflation.)
Over time, the growth in GDP causes inflation, and inflation begets
hyperinflation. Once this process is in place, it can quickly become a
self-reinforcing feedback loop. This is because in a world where inflation is
increasing, people will spend more money because they know that it will be less
valuable in the future. This causes further increases in GDP in the short term,
bringing about further price increases. Also, the effects of inflation are not
linear; 10% inflation is much more than twice as harmful as 5% inflation. These
are lessons that most advanced economies have learned through experience; in
the U.S., you only need to go back about 30 years to find a prolonged period of
high inflation, which was only remedied by going through a painful period of
high unemployment and lost production as potential capacity sat idle.
"Say When"
So how much inflation is "too much"? Asking this question uncovers another big
debate, one argued not only in the U.S,. but around the world by central
bankers and economists alike. There are those who insist that advanced
economies should aim to have 0% inflation, or in other words, stable prices.
The general consensus, however, is that a little inflation is actually a good
thing.
The biggest reason behind this argument in favor of inflation is the case of
wages. In a healthy economy, sometimes market forces will require that
companies reduce real wages, or wages after inflation. In a theoretical world,
a 2% wage increase during a year with 4% inflation has the same net effect to
the worker as a 2% wage reduction in periods of zero inflation. But out in the
real world, nominal (actual dollar) wage cuts rarely occur because workers tend
to refuse to accept wage cuts at any time. This is the primary reason that most
economists today (including those in charge of U.S. monetary policy) agree that
a small amount of inflation, about 1-2% a year, is more beneficial than
detrimental to the economy.
The Federal Reserve and Monetary Policy
The U.S. essentially has two weapons in its arsenal to help guide the economy
toward a path of stable growth without excessive inflation; monetary policy and
fiscal policy. Fiscal policy comes from the government in the form of taxation
and federal budgeting policies. While fiscal policy can be very effective in
specific cases to spur growth in the economy, most market watchers look to
monetary policy to do most of the heavy lifting in keeping the economy in a
stable growth pattern. In the United States, the Federal Reserve Board's Open
Market Committee (FOMC) is charged with implementing monetary policy, which is
defined as any action to limit or increase the amount of money that is
circulating in the economy. Whittled down, that means the Federal Reserve (the
Fed) can make money easier or harder to come by, thereby encouraging spending
to spur the economy and constricting access to capital when growth rates are
reaching what are deemed unsustainable levels.
Before he retired, Alan Greenspan was often (half seriously) referred to as
being the most powerful person on the planet. Where did this impression come
from? Most likely it was because Mr. Greenspan's position (now Ben Bernanke's)
as Chairman of the Federal Reserve provided him with special, albeit un-sexy,
powers - chiefly the ability to set the Federal Funds Rate. The "Fed Funds"
rate is the rock-bottom rate at which money can change hands between financial
institutions in the United States. While it takes time to work the effects of a
change in the Fed Funds rate (or discount rate) throughout the economy, it has
proved very effective in making adjustments to the overall money supply when
needed. (To continue reading about the Fed, see Formulating Monetary Policy,
The Federal Reserve and A Farewell To Alan Greenspan.)
Asking the small group of men and women of the FOMC, who sit around a table a
few times a year, to alter the course of the world's largest economy is a tall
order. It's like trying to steer a ship the size of Texas across the Pacific -
it can be done, but the rudder on this ship must be small so as to cause the
least disruption to the water around it. Only by applying small opposing
pressures or releasing a little pressure when needed can the Fed calmly guide
the economy along the safest and least costly path to stable growth. The three
areas of the economy that the Fed watches most diligently are GDP, unemployment
and inflation. Most of the data they have to work with is old data, so an
understanding of trends is very important. At its best, the Fed is hoping to
always be ahead of the curve, anticipating what is around the corner tomorrow
so it can be maneuvered around today.
The Devil Is in the Details
There is as much debate over how to calculate GDP and inflation as there is
about what to do with them when they're published. Analysts and economists
alike will often start picking apart the GDP figure or discounting the
inflation figure by some amount, especially when it suits their position on the
markets at that time. Once we take into account hedonic adjustments for
"quality improvements", reweighting and seasonality adjustments, there isn't
much left that hasn't been factored, smoothed, or weighted in one way or
another. Still, there is a methodology being used, and as long as no
fundamental changes to it are made, we can look at rates of change in the CPI
(as measured by inflation) and know that we are comparing from a consistent
base.
Implications for Investors
Keeping a close eye on inflation is most important for fixed-income investors,
as future income streams must be discounted by inflation to determine how much
value today' money will have in the future. For stock investors, inflation,
whether real or anticipated, is what motivates us to take on the increased risk
of investing in the stock market, in the hope of generating the highest real
rates of return. Real returns (all of our stock market discussions should be
pared down to this ultimate metric) are the returns on investment that are left
standing after commissions, taxes, inflation and all other frictional costs are
taken into account. As long as inflation is moderate, the stock market provides
the best chances for this compared to fixed income and cash.
There are times when it is most helpful to simply take the inflation and GDP
numbers at face value and move on; after all, there are many things that demand
our attention as investors. However, it is valuable to re-expose ourselves to
the underlying theories behind the numbers from time to time so that we can put
our potential for investment returns into the proper perspective.
by Ryan Barnes