By: Montana Timpson
Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programs, tax policies and interest rates. For the professional trader, understanding inflation is crucial, because fluctuations in inflation can have a robust effect on the value of investment returns.
By definition, inflation is a sustained rise in price levels, measured by the Bureau of Labor Statistics (BLS). The BLS is responsible for two key inflation indicators: the Consumer Price Index (CPI) and Producer Price Index (PPI). CPI, which reflects retail prices of goods and services, including housing costs, transportation, and healthcare, is often the most widely followed indicator of inflation.
As an economy grows, demand typically outstrips the supply of available goods and services, and as a result, the rate of inflation increases. If economic growth accelerates rapidly, an upward price spiral, sometimes called “runaway inflation” or “hyperinflation,” can result.
In contrast, when economic growth begins to slow, demand eases and the supply of goods increases relative to demand. At this point, the rate of inflation usually drops. This period of falling inflation is often referred to as “disinflation.”
Inflation and Investment Returns
For investors aimed at increasing long-term purchasing power, inflation rates can pose a threat of decreasing real savings and investment returns, but for active traders, inflation may pose valuable trading opportunities as the prices of securities rise and fall in line with inflation rates over the long term.
Unlike bonds, where the purchasing power of the interest payments declines, securities often see a rise in price as inflation increases. Equities have often been a good investment relative to inflation over time because companies can raise prices for their products when their costs increase in an inflationary environment. In this way, higher prices often translate into higher earnings. However, over shorter time periods, stocks have often shown a negative correlation to inflation and can be especially hurt by unexpected inflation. When inflation rises suddenly or unexpectedly, it can heighten uncertainty in the economy, leading to lower earnings forecasts for companies and lower equity prices.
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