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The Importance Of Inflation And GDP

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