Answer questions on inflation

Some of you have asked to explain inflation and interest rate. Since the question is very broad, I will try to explain it in high level. I believe once you understand the basic concept, you will be able to grasp the more difficult material due to inflation.

First of all, inflation is one of the important elements that macroeconomics focuses on (on top of unemployment, recessions, government spending & taxation, budget deficits, national debts…etc). I believe everyone has a rough idea of the meaning of inflation, but does everyone know what is a real inflation and what is not a real inflation?

Inflation arises when prices are increasing. This is challenging because as prices increase, money starts to lose its value, as you need more and more money to buy the same amount of goods and services and this has a negative impact on living standards. Inflation is an important economic measurement for securities markets too because it is the rate at which the real value of an investment is eroded.

-          A one-time upsurge in prices caused by a rise in the oil price or a new tax implementation is not true inflation, unless it feeds into wages and other costs and generate a wage-price spin.

-          A price increase of one product is not in itself inflation, but may just mirror the shortage of that product.

Now that we know what inflation is really, let’s look at the cost of inflation impose on the economy:

     -      It reduces the standard of living of those on a fixed income and those who lack wage bargaining power.

     -      It decreases reduces the real value of investments such as fixed-rate loans, since the loans are paid back in dollars that buy less. Most likely, inflation results in lenders demanding a higher interest rate on the money they lend.

    -       Inflation increasing at a fast pace usually results into rising interest rates and a recession. Thus, high inflation economies usually see more severe booms and busts than low-inflation economies.

Having the basic understanding of inflation and its impact, it is important that you understand the cause of inflation:

A critical factor of inflation is the balance between supply and demand conditions in the economy. Economists use a measurement called the output gap to gauge inflation pressures in the economy by looking at the difference between real GDP, what the economy actually generates, and potential GDP, what the economy is capable of generating when its existing inputs of labour, capital, and technology are fully utilized at their normal levels of use.

• A negative output gap happens when actual output is below potential output. In this case, there is spare capacity in the economy – the economy can manufacture more output because its resources are not being employed to their full capacity. Unemployed workers and unused factory and equipment resources can be called into service without influencing wages or prices. Thus, inflation will fall or remain steady.

• A positive output gap happens when actual output is above potential output. In this case, the economy is operating above capacity – the economy is trying to generate more than it can with existing resources. Scarce labour stimulates in wage increases, and other strains on productive resources gives pressure on inflation.

In general, a positive output gap when output continues to expand, consumer income is rising, and this leads to strong consumer demand for goods and services. But this creates a situation whereby if companies can continue to operate well above normal capacity, they can increase prices in response to this strong demand. In this way, higher and continued consumer demand pushes inflation higher. This situation is called demand-pull inflation.

• Inflation can also occur due to shocks from the supply side of the economy – when the cost of manufacturing output changes. When faced with higher production cost from higher wages or rise in the price of raw materials, companies react by increasing prices and manufacturing a smaller amount of their product. In this way, the higher costs push inflation higher. This is called cost-push inflation.

How do we measure inflation?

The Consumer Price Index (CPI) is one of the most largely used statistics of inflation and is considered a measure of the cost of living.

For example: The CPI was 121.8 in August 2012 and 120.3 in August 2011. The inflation rate over the 12-month period is calculated as followed:

Source: CSC

How inflation impacts the interest rate?

In short, inflation plays an important role in determining the level of nominal interest rate (i.e. the rate charged by a bank on a loan, or the quoted rate on an investment such as GIC or Treasury bill). Other things being equal, the greater the rate of inflation, the greater nominal interest rates will be.

Please note that real interest rate is the nominal interest rate minus the expected inflation rate.

I would conclude that as an investor who makes an investment decision to buy a security, based on a forward-looking expectation about the future return of the security, I would also consider inflation especially if I am buying a fixed income security as it can decrease the value of my investment.

I hope this helps. Since it is very broad and high level explanation, I would encourage you to review related chapter on the CFA curriculum.