- Inflation The economics you hear and read about in the financial press usually goes beyond the simple concept of supply and demand. It is important to get a grasp of at least some of the economic concepts that affect the markets. Doing so can have a significant positive impact on your financial future.

What is Inflation? One of the most important economic concepts is inflation. At its most basic level, inflation is simply a rise in prices. Over time, as the cost of goods and services increase, the value of a dollar is going to go down because you won't be able to purchase as much with that dollar as you could have last month or last year. Of course, it seems like the cost of goods are always going up, at least to an extent, even when inflation is thought to be in check. It is important to note that some amount of inflation is considered normal (actually, as we explain below, because of its relationship with unemployment, some inflation is actually desirable). While the annual rate of inflation has fluctuated greatly over the last half century, ranging from nearly zero inflation to 23% inflation, the Fed actively tries to maintain a specific rate of inflation, which is usually 2-3% but can vary depending on circumstances. Deflation (for example, -1%) occurs when prices actually decrease over a period of time. Please note that deflation is not the same as disinflation, which is when the rate of inflation decreases but stays positive (for example, a change from a 3% rate to a 2% rate).

How Inflation is Measured There are two main indices used to measure inflation. The first is the Consumer Price Index, or the CPI ( CPI). The CPI is a measure of the price of a set group of goods and services. The "bundle," as the group is known, contains items such as food, clothing, gasoline, and even computers. The amount of inflation is measured by the change in the cost of the bundle: if it costs 5% more to purchase the bundle than it did one year before, there has been a 5% annual rate of inflation over that period based on the CPI. You will also often hear about the "Core Rate" or the "Core CPI." There are certain items in the bundle used to measure the CPI that are extremely volatile, such as gasoline prices. By eliminating the items that can significantly affect the cost of the bundle (in either direction) on a month-to-month basis, the Core rate is thought to be a better indicator of real inflation, the slow, but steady increase in the price of goods and services.

The second measure of inflation is the Producer Price Index, or the PPI ( PPI). While the CPI indicates the change in the purchasing power of a consumer, the PPI measures the change in the purchasing power of the producers of those goods. The PPI measures how much producers of products are getting on the wholesale level, i.e. the price at which a good is sold to other businesses before the good is sold to a consumer. The PPI actually combines a series of smaller indices that cross many industries and measure the prices for three types of goods: crude, intermediate and finished. Generally, the markets are most concerned with the finished goods because these are a strong indicator of what will happen with future CPI reports. The CPI is a more popular measure of inflation than the PPI, but investors watch both closely ( Economic Indicators).

Inflation and Your Investments Inflation is greatly feared by investors because it grinds away at the value of your investments. Put simply, $100 today is not the same as $100 in 1 or 10 years. It is crucial to include measures of expected inflation when calculating your expected return on investment. As the most basic example, if you invest $1000 in a 1-year CD that will return 5% over that year, you will be giving up $1000 right now for $1050 in 1 year. If over the course of that year there is an inflation rate of 6%, the purchasing power of $1000 has decreased by $60, and you have actually lost ground! (Of course, the capital gains taxes you pay on your "gain" will increase this loss.) If you had spent that $1000 instead of investing it, you would have been able to purchase a larger bundle of goods than was possible with the $1050 you earned a year later. However, this is not a suggestion that you spend your money instead of saving it. First, the reasons to save are too numerous to list, but a home and retirement should be enough to inspire you. Given that savings are important, inflation eats away at your purchasing power more if you just put your savings under your mattress than if you had invested it. Now that this issue has been clarified, it is important to be aware of the effects of inflation on your investments. Whenever you can, try to determine your "real rate of return", which is the return you can expect after factoring in the effects of inflation. If you are working with a financial professional, ask him or her for an estimate of the real rate of return of a given investment or portfolio. As explained, inflation can erode the value of cash investments, such as stocks, bonds, and CDs. However, some people believe that investments in real goods, such as a home, are protected from inflation. This is because the value of a real good is determined to a large extent by its intrinsic nature, as opposed to money, which is valued only for what you can trade it for. If inflation is high, the price of a home or a car may simply increase at a similar rate, insulating it from price erosion. The same cannot be said for a 10-year bond. As a result, some investors seek protection from inflation, and investment options which do just that are becoming available. The most popular example is TIPS - Treasury Inflation Protected Securities. These investments are just like bonds except that they are insulated from the effects of inflation ( TIPS).

The description above explains why investors follow CPI and PPI reports so closely. In addition to being aware of the current rate of inflation, it is crucial to be aware of what inflation rate the experts are anticipating. Both the value of current investments and the attractiveness of future investments will change depending on the outlook for inflation.

Inflation and Unemployment Many modern economists believe that inflation is inversely related to unemployment. This relationship is shown through something called the Phillips Curve. The Phillips Curve shows the relationship between a given level of inflation and the expected level of unemployment that would go along with it. As inflation decreases, unemployment is expected to rise. This relationship is why you hear about the Fed's dual tasks of keeping inflation in check and maintaining full employment. Economists agree that there is a minimum level of unemployment that an economy can handle without causing inflation to accelerate ( Federal Reserve System).

Inflation and Interest Rates Interest rates measure the price of borrowing money. If a business wants to borrow $1 million from a bank, the bank will charge a specific interest rate that will usually be expressed in terms of a percentage over a given period of time. For example, if the bank loaned the money to the company at a 5% annual rate, the company would need to repay $1,050,000 at the end of the year. From the company's perspective, the value of that $1,000,000 right now is greater than the $1,050,000 in a year (presumably because they have plans for the money), which is why they want to borrow it. For the bank, it is earning a 5% return on a one-year investment. Generally, there are two types of interest rates: floating and fixed. A floating rate, also called an adjustable rate, moves in step with a rate that is set outside of the lending institution, such as the prime rate (the rate at which banks lend to their best customers). For example, you might see a rate set at "prime plus 2%". This means that the rate on the loan will always be 2% higher than the prime rate, which changes regularly. The prime rate changes to take into account the changes in inflation. The "real" interest rate is the nominal (stated) rate minus the rate of inflation. For example, if a bank were to give you a loan at the nominal rate of 9% and inflation was measured at 3%, the real interest rate that the bank earns would be 6%. Banks change nominal interest rates to stabilize the real interest rates they receive. A fixed rate is an interest rate that does not change for the life of the loan. For an individual taking out a loan when rates are low, the fixed rate loan would allow him or her to "lock in" the low rates and not be concerned with fluctuations. On the other hand, if interest rates were historically high at the time of the loan, he or she would benefit from a floating rate loan, because as the prime rate fell to historically normal levels, the rate on the loan would decrease.

Interest Rates and the Fed Interest rates change on a regular basis. The rates that you pay on a mortgage or other type of loan will vary from day-to-day and week-to-week based on many macroeconomic variables, including inflation, unemployment rates, growth rates, tax laws, and the Fed's policies and outlook. The Fed affects interest rates by setting two key rates, the discount rate and the federal funds rate. The discount rate is the rate which the Federal Reserve Bank charges its member banks for overnight loans. The Fed actually controls this rate directly, but it tends to have little impact on the activities of banks because these funds are also available elsewhere. The federal funds rate is the interest rate at which banks loan excess reserves to each other. While the Fed can't directly affect this rate, it effectively controls it in the way it buys and sells Treasuries to banks. This is the rate that reaches individual investors, though the changes usually aren't felt for a period of time ( Fed and Monetary Policy).

So, why should the average investor care about interest rates? Of course, interest rates affect things such as loans and mortgages, but they also have an effect on the markets as well. As rates change, the demand for different types of investments will change as well. During periods of low interest rates, stocks are considered more attractive than bonds and other fixed interest investments-the price the banks and other institutions are willing to pay to borrow your money has gone down. Similarly, periods of high interest rates are considered bad for stocks because safer investments earn higher returns. Moreover, the interest rate picture is often seen as an indicator for the economy on a large scale. High interest rates mean it is more expensive for businesses to borrow money to expand and will also likely decrease consumer spending.

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