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Strategies & Market Trends : Currencies and the Global Capital Markets -- Ignore unavailable to you. Want to Upgrade?

To: Ahda who wrote (2547)	9/4/2000 11:34:42 PM
From: David Michaud	Read Replies (1) \| Respond to of 3536

Why do things seem to cost more and more each year? And why does it seem as if every couple months we hear about inflation and how the stock market has tanked because of inflation fears? Inflation itself is a tough concept to grasp, because we have so many ways to measure it. What is Inflation? So you wonder why the price of a pack of gum has gone from 50 cents over 5 years ago to almost 75 cents now? The truth is that it isn't the gum company trying to gouge you, the answer is inflation. The dictionary states that inflation is the rate at which the general level of prices for goods and services is rising, and subsequently purchasing power is falling. As inflation rises this means that every dollar you own will buy less % of a good or service. For example if the inflation rate is 2% annually then hypothetically a $1 pack of gum will cost $1.02 in a year. The fed tries to sustain an inflation rate of between 2-3%. As you can imagine if inflation gets out of hand at 5 or 10% the results can be much larger. What you could buy in 1972 for $1.00 would cost $3.78 in 1994. In fact there are cases in Eastern Europe and South America where annual inflation was well over 1000%. Grocers would change the prices of goods on an hourly basis to account for the run-away inflation. How is Inflation Measured? Now that we have a basic grasp of inflation lets see how it is measured. There are really two major sources of information that government officials and the media use to detect inflation: Consumer Price Index (CPI) - a measure of price changes in consumer goods and services such as gasoline, food, clothing and automobile's. It is one of the most used statistics to identify periods of inflation or deflation. It usually has a big impact on the movement of stock prices on the day that it is released. Producer Price Index (PPI) - A family of smaller indexes that measures the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller and manufacturer. The PPI looks at three areas of production Industry-based, Commodity-based, Stage-of-processing based companies. Of the two indexes the CPI is the most popular and powerful when it comes to detecting inflation. Each month, the Bureau of Labor Statistics of data collectors called economic assistants visit or call thousands of retail stores, service establishments, rental units, and doctors' offices, all over the United States to obtain price information on thousands of items used to track and measure price change in the CPI. They record the prices of about 80,000 items each month. These 80,000 prices represent a scientifically selected sample of the prices paid by consumers for the goods and services purchased. Inflation and Interest Rates So why is it that when ever you hear the latest inflation data that the word "interest rates" are soon to follow? Interest rates are decided by the Federal Reserve which meets times a year to set short-term interest rate targets. The major pieces of data that the federal reserve uses for their decision is the CPI and PPI results. Remember that interest rates directly effect the credit market (loans) because a higher interest rate makes borrowing more costly and reducing disposable income. By changing interest rates the Fed tries to achieve maximum employment, stable prices and moderate growth. Generally, a tightening (rate increase) attempts to head off future inflation, while an easing (rate decrease) hopes to spur economic growth. As interest rates get higher the result is slow consumer spending (the premise of economic growth) by making financing more expensive. But inflation is not the only factor that affects the Feds decision on interest rates. During a financial crisis the Fed might ease interest rates to provide liquidity to U.S. Financial markets, preventing a more catastrophic market meltdown. Inflation and Equities As we mentioned in the previous lesson on interest rates and inflation, an increase of inflation generally means higher interest rates to slow the economy. This is the premise of stocks declining on inflation fears. If the Federal Reserve decides they should slow the economy by increasing interest rates then corporate America gets hurt the most. Investors realize that making it more expensive to borrow means less disposable income and less demand for consumer products. The bottom line is that companies such as grocery stores, alcoholic beverages, and airlines' who specialize in selling luxury items suffer. Since stock prices reflect corporate profits, a reduction in consumer spending means a lower stock price. In Conclusion We are only scratching the surface on inflation, in post-secondary institutions there are entire courses that discuss the impact, factors, and prevention's of inflation. Remember that inflation is the rate at which prices for goods and services are rising at. This is usually spurred by excess demand for consumer goods, to stop run away inflation the Federal Reserve will increase interest rates. This reduces consumer demand and slows down the economy. The ultimate losers of the slowdown are corporations specializing in luxury items such as travel agents - hurting the stock market.