Inflation

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Inflation is a measure of how much the general level of prices for goods and services is rising over time. In other words, as inflation rises, the purchasing power of every unit of currency is decreasing. as a result. Some inflation is to be expected, though countries' central banks usually try to prevent excessive increases in the prices of goods and services.

There is an ongoing scientific discussion as to whether inflation is defined by rising prices or by the expansion of the money supply, a thesis represented by economists of the Austrian school of economics. Inflation is self perpetuating. When expectations of inflation are high due to a large increase in the money supply, consumers become accustomed and conditioned to expect rising prices. And to the extent they accept the idea of paying more, inflation feeds on itself. Rising prices beget rising prices.


Companies Most Hurt by Unexpected Inflation

The economy as a whole suffers when there is unexpected inflation, however, lenders in particular suffer.

Banks and other institutions usually lend money at fixed rates, and so the amount of money that a borrower has to pay back to the lender is usually fixed as well. The rate that the lender charges is supposed to be enough to cover inflation and still provide some profit; the difference between inflation and the rate banks charge is called the lending spread. If inflation suddenly increases more than was expected, lenders can be faced with the situation in which the money borrowers pay back, while the same in nominal terms, is much less in real terms. For example, if a bank charges 2% on a loan but inflation unexpectedly increases to 4% after the loan is completed, the bank will actually lose money on the loan.

Measures of Inflation

There are eight main indexes used to gauge inflation, each constructed and calculated in a different way: the consumer price index (CPI), producer price index (PPI), personal consumption expenditure (PCE) deflator, and gross domestic product (GDP) deflator, and a core version of each, which excludes food and energy.

Consumer Price Index (CPI)

The consumer price index (CPI) is constructed by measuring the change in price of a weighted basket of goods thought to be purchased by the average urban consumer. For this reason, the CPI measures changes in the cost of living.[1] Due to several biases, such as the substitution effect, many of which the BLS continually tries to make smaller, it is contended by some economists that the CPI overestimates true inflation by up to 1%.[1]

Producer Price Index (PPI)

The producer price index (PPI) measures the average change over time in the selling prices received by domestic producers for their output. [2] This index differs from the CPI because many products are sold to other businesses, and not consumers. The CPI only captures changes in the price of products sold to consumers, and not to businesses.[3] For this reason, the PPI measures changes in revenue, equivalent to changes in output.

Personal Consumption Expenditure (PCE) Deflator

The personal consumption expenditure deflator measures the average change over time in the price paid for all consumer purchases.[4] For this reason, the PCE deflator measures changes in the cost of living, and because it measures the price paid for all consumer purchases, versus just a basket of goods, it is considered a more accurate measure of inflation than the CPI.[5]

GDP Deflator

The gross domestic product deflator measures the average change over time in the price paid for all expenditures.[6] For this reason, the GDP deflator measures changes in output, and is used to calculate real GDP growth.

Core Indexes

When economists cite inflation numbers, they usually refer to the core version of the index, a version with food and energy excluded. This is done because food and energy prices are highly volatile, and cloud information about the price changes of goods with more stable supply and demand, like toys and refrigerators.[7] Rising oil and food prices, for example, negatively impact the revenues of businesses outside the food and oil industries, but should not be used by an investor to assume that headline (not core) inflation will be high in the future. For example, from 2008 to 2009 oil prices fell by over 50%, causing headline inflation to fall by more than core inflation. However, because oil prices fluctuate so much, it is much more likely that core inflation in 2010 will be close to what it was in 2009 than headline inflation in 2010 being close to what it was in 2009.[8] Food and energy prices fluctuate so much because they are effected by temporary factors that may reverse themselves later, like a particularly dry season which may turn into a fertile season, or an oil supply cut by OPEC which may be stopped later.[7]

Inflation Expectations

Expectations of inflation by economists, households, and investors are important for two main reasons. First, expectations of inflation have historically been accurate forecasts of future inflation. Second, expectations themselves play a large role in impacting future inflation, making them even more accurate in predicting future inflation.

Treasury Inflation-Protected Securities (TIPS) Spread

TIPS give an investor a fixed real return because the principal and interest payments are tied to the CPI. Regular treasury securities are not tied to the CPI, so we can look at the difference in the rates of return between the two securities to infer how much inflation investors might see over different time horizons. This measure is imperfect, however, as the TIPS market is illiquid, which introduces a liquidity premium, and because regular securities are vulnerable to fluctuations in inflation, introducing a risk premium.[9] The Cleveland Fed previously calculated and removed these premiums from the TIPS spread, but discontinued this practice in October 2008, with extreme market conditions in 2008 and 2009 making liquidity premiums hard to accurately calculate.[10]

Yield Curve

The behavior of long term rates relative to short term rates along the yield curve can help determine market expectations of inflation. A steepening of the yield curve- that is, a rise in long term rates relative to short term rates, might signal that bond buyers are demanding more protection against inflation. However, the yield curve is affected by many other factors as well, making this an imperfect measure of inflation expectations.[11]

University of Michigan Inflation Expectation

The University of Michigan inflation expectations survey interviews about 500 households around the nation asking people how much they think prices will rise in the next 12 months and over the next 5 to 10 years. Typically, beliefs of households about future inflation are much higher than normal, and have a smaller role in impacting future inflation than investor expectations of inflation. The former is true because households tend to base their estimates of future inflation based solely on previous inflation, rather than on previous inflation in addition to other factors, like changing supply or demand.[12]

Survey of Professional Forecasters (SPF)

The SPF interviews economists every quarter about their forecasts for macroeconomic variables like GDP growth and CPI inflation over several time horizons.[13] As the SPF forecasts long term inflation and is taken by professional economists, it is held to be more accurate than shorter term surveys of inflation.[14]

Effects of inflation

Inflation represents an increase in the prices of goods, as well as a decrease in the purchasing power of every unit of currency. Today, it is generally accepted doctrine that a relatively low level of inflation (1% to 4% annually) is acceptable or even beneficial, Too much inflation, or unexpected increases in the rate of inflation, can be harmful, however. Inflation can hurt a variety of companies and industries, particularly lenders. Additionally, people living on fixed incomes, like retirees or the disabled, can be harmed by the reduction of their incomes' spending power. Payments from government-sponsored programs are readjusted periodically for inflation, but this often occurs only once a year. In the time between adjustments, sudden inflation can result in lower spending power for people on fixed incomes, lowering their standard of living and decreasing their consumption of goods and services. Fixed incomes from private sources, such as employer pension plans, may or may not be readjusted for inflation at all, subjecting people dependent on these payments to inflationary risks.

In addition, higher rates of inflation can cause general uncertainty about the future direction of the economy as a whole. This can lead to hesitation among individuals and corporations to spend money until they feel comfortable about future economic conditions. The resulting decline in spending would further impact the economy, hurting providers of goods and services. At the same time, rising prices often leads workers to expect higher wages to compensate. This demand for higher wages, combined with the decrease in demand for goods and services, can lead to higher unemployment as firms are forced to lay off workers. Also, companies can incur what are known as "menu costs", or the costs of changing the prices for goods and services. This includes recalculating the actual costs themselves as well as updating any signs or price lists to account for the changes. While seemingly insignificant, this can amount to a significant cost across the economy.

Infaltion generally harms most people in an economy. However, provided that economic activity continues at a respectable pace, inflation that is accelerating modestly does benefit those who hold relatively high levels of real assets (i.e. property, commodities, etc.) and similtaneously hold relatively high levels of fixed-rate debt. That is because the rate of inflation revalues the assets higher, while the relative cost of servicing the debt (and its relative value) decline.

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The Cost of Inflation and Deflation[15] [16] [17]


The Cost of Deflation

Deflation is worse than inflation. This is because:

  • Deflation almost always occurs when demand for goods declines, ie. when spending slows down and businesses loose revenues.[18]
  • As businesses lose revenues, they are forced to cut wages and jobs, further harming the economy.[19]
  • As most contracts are written with the expectation of inflation, when deflation occurs there is an arbitrary redistribution of wealth from borrowers to lends.[19]
  • Deflation is costly to escape from.[16]

Hyper Inflation

Hyper inflation, a rapid increase in the price level, is worse than both moderate inflation and deflation. One famous example of sudden, severe inflation occurred in Germany from 1922 to 1923. By some estimates, prices in Germany during this time period doubled every two days, on average. Companies had to pay their employees twice daily as workers would lose too much purchasing power otherwise. In the end, it was cheaper to burn billions of Reichsmarks than to buy firewood for heating. Other pictures of the time showed ordinary Germans paying for a loaf or two of bread with a wheelbarrow full of currency. All savings were effectively erased, bankrupting more or less the whole country.

The root of Germany's slide into hyper inflation is attributed to overly harsh sanctions following World War One. In its efforts to service foreign debts, Germany issued more and more government bonds which were sold to the Deutsche Reichsbank. The new debts only accelerated the downfall of the currency which traded at 4:1 with US Federal Reserve Notes at the beginning of the crisis. At the end of 1923 one Federal Reserve Note had an exchange rate of 4.2 trillion Reichsmark.

At the end of the German hyper inflation - which was a precursor to Germany's great depression - only 1% of German government funds came from tax revenues while 99% came fresh off the printing presses. Germany, aka the Weimar Republic, then boasted to have set up 23 printing presses all over the country which were run around the clock.

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A German banknote from August 1923.

While there is no strict arthimetical number that defines hyper inflation, it can generally be thought of as prices that are out of control. Generally, this would equate to at least a double digit rate per month, and at least triple digit on an annual basis. For a recent example of hyperinflation, one needs only to look to Zimbabwe since 2002.

Annual inflation in Zimbabwe was estimated to exceed 10 million percent in 2008. In a desperate move the government cut off 10 zeroes from all bills. This didn't help to rein inflation as the Zimbabwean government follows Germany's bad example from the last century. Cut off from external funding the Zimbabwean government has been relying on the printing press in order to finance its budget.

This highlights the importance of inflation as both an indicator of economic conditions and as a driving force behind changes in those conditions.

Historically, all fiat currencies (i.e. not backed by gold and/or silver) ultimately suffered through some form of complete value deterioration, with hyper inflation being the most extreme example of rapid value destruction.

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