LEVEL: INTERMEDIATE
Inflation is one of the vicious enemies of the marketplace, eroding purchasing power, business profits and the value of investments.
Inflation is insidious. When it spirals out of control, it can have a political as well as economic impact. In 1992, after the fall of the Soviet Union, inflation in Russia was at 2,000 percent and President Boris Yeltsin was struggling to cope with the threat to his government.
At the Group of Seven economic summit in Munich, then-British Prime Minister John Major warned Yeltsin of the dangers of inflation, telling him it was the seed of revolution. Yeltsin heeded and took the tough measures necessary, shaking up his government to promote inflation fighters.
Despite the dangers of unrest, Russia was not close to the inflation leaders in the past 100 years. Economists say Hungary went through the worst inflation ever recorded between the end of 1945 and July 1946. Germany’s Weimar Republic in the early 1920s and Zimbabwe from 2004 to 2008 both outpaced Russia in sky-rocketing inflation.
Most countries don’t have to worry about revolutions over inflation, but there are other factors of concern. Inflation indicators measure how fast prices are rising, giving central bankers a good guide for raising or lowering interest rates. Whenever the political mandate is to curb prices, central bankers go to great lengths to achieve inflation goals.
Two key inflation indicators take center stage in the U.S., Consumer Price Index (CPI) and Producer Price Index. CPI measures inflation at the retail level and PPI at the wholesale level. In the U.S., the Department of Labor publishes both reports monthly.
When the statistics are released, the market typically will have an instant reaction, depending how the actual data compares to expectations. In a healthy economy, stock prices likely would fall if the CPI showed that inflation rose sharply beyond market expectations. This could mean the economy is growing too fast and the Federal Reserve would consider interest rate hikes to put the brakes on.
The U.S. and many global economies have been in a recessionary mode recently, however, and inflation hasn’t been a major problem. For example, the Bureau of Labor Statistics calculates that $100 in 2005 would have inflated to $117.31 by 2012. From 2007 to 2012, $100 would have inflated value of $110.50 as a result of the recession.
Federal Reserve officials in the current sluggish economy must decide whether to stimulate monetary policy with a third round of quantitative easing, or QE3. The Fed has already bought about $2.3 trillion in bonds to try and stimulate the economy. But with the economic recovery still tepid, there are calls for more easing. Inflation remaining low would enable the central bank to launch QE3 without fear of causing unacceptable price rises.
To curb inflation, the Fed has several tools. It can raise short-term interest rates: either the federal funds rate or the discount rate. If the need is great enough, they might hike both. Higher interest rates mean lower corporate profits as corporations’ interest expense goes up and profits fall. That would be a reason to sell stocks. Bond prices would fall, the yields would rise and stocks would trade lower. The effect would be felt on global markets, because of the influence of the U.S. stock and financial activity.
The U.S. dollar might make an impulsive move higher because dollar-denominated assets would earn more if interest rates were higher. If traders believe there is an actual presence of inflation, however, then the dollar would move lower because inflation erodes the value of investments. Higher inflation can also cause some investors to move from stocks and bonds to harder assets such as gold.
Beyond the initial reactions, economists will examine the data closely to spot underlying trends. Those sub-categories are food, housing, apparel, transportation, medical care, recreation, education and communication. Gasoline prices are always watched closely because of the jump in crude oil costs during the past few months.
As for the PPI, analysts and economists watch the wholesale data because it can be a warning signal. They note how much inflation is creeping in at the wholesale and “factory gate” levels of the economy. The premise is that the rise will at least in part be passed on to consumers and will lead to an across-the-board increase in CPI inflation.
Like the CPI, there is a headline number in the PPI and a core number, which strips out the volatile energy and food prices.
One of the main differences between the PPI and the CPI is that the PPI excludes service prices and measures only commodities. The PPI surveys more than 3,000 commodities through approximately 40,000 survey participants.
PPI is more volatile than the CPI, some analysts note, because the two volatile sectors, food and energy, are given a higher weighting. Even the core PPI is more volatile than its CPI counterpart because service inflation is less mercurial than goods inflation.
The market also knows that the Federal Reserve is only able to keep core inflation in the economy under control. If prices rise due to special, one-time factors, such as OPEC or Mideast unrest restricting production and increasing demand for oil, the Federal Reserve is restricted in its approach.
Inflation numbers will be reported as follows:
- CPI:
September 14, 2012
October 16, 212
November 15, 2012
December 14, 2012 - PPI:
September 13, 2012
October 12, 2012
November 14, 2012
December 13, 2012