Inflation is out of the bottle and the rise is stronger than anyone had expected. But what exactly is being measured? What key figures are used? What do they say? And what does inflation mean for the financial markets? A list from the Basel financial house Dreyfus Banquiers provides clarity.
Inflation is measured and reported in varying amounts. For companies, the primary focus is on the development of producer prices, while consumers use the consumer price index as a guideline. In the United States, a price index for private consumption is also used. The consumer price index distinguishes between overall inflation and core inflation. Seasonal fluctuations are filtered out as far as possible.
In its latest “Compass” publication, the Basel-based private bank Dreyfus Banquiers impressively presents exactly what the individual variables are about and the significance of inflation for the financial markets. The show deserves to be presented to a wider audience. Even professional investors may find one or the other of the slightly abbreviated explanations below useful.
Inflation factors: The unusually high inflation cannot be attributed to a single cause, it is rather a combination of different factors. First, because of the war in Ukraine, there are energy and food prices. On the other hand, bottlenecks in global supply chains, Covid-related shutdowns in China and an unusually expansive monetary and fiscal policy during the pandemic have led to inflation. Above average consumption of goods and the trend towards renewable energy also contribute to the inflationary environment.
What used to be true is now obsolete
Inflation and economic growth: Until the 1970s, it was believed that a government could increase growth by accepting higher inflation. As inflation rose sharply in the following years, while the economy grew only slightly or even shrank, this correlation was increasingly questioned. Today, the majority of economists agree that high inflation has a negative effect on economic development. Due to the greater uncertainty, it reduces the willingness of businesses and households to invest and consume. On the other hand, stable low inflation around 2% may be conducive to growth.
inflation and economic growth
Consumer price (CPI) and producer price index (PPI): They both measure the inflation of a defined basket of goods. However, the content is different. The goods and services included in the CPI are those typically consumed by urban dwellers. This corresponds to the average price change for each item in the basket. In contrast, PPI measures the change in sales prices for raw materials and intermediates. These include mining, manufacturing, agriculture and construction. Because these sales prices directly affect retail prices, PPIs are considered a leading indicator of inflationary pressures.
Eliminate seasonal effects
Overall inflation and core inflation: Overall inflation is the figure reported as the consumer price index. It shows the development of the cost of living and contains all elements of an economy that are relevant to inflation. Core inflation removes the CPI components, which can fluctuate greatly from month to month, which can introduce unwanted skew in the total. The most commonly removed components are food and energy.
US Headline and Core Inflation
Personal consumption price index: The US Federal Reserve uses the PCE (Personal Consumption Expenditure) price index instead of the CPI to define its inflation target. Although both indices calculate the price level from a shopping cart, CPI only records expenses for items paid out of pocket. Other expenses that are not paid directly are only included in the PCE, such as medical expenses covered by insurance paid for by the employer.
The main difference, however, is how the indices take into account changes in the shopping basket. Unlike CPI, PCE takes into account substitution of goods and adjusts the basket of goods accordingly. For example, when the price of bread rises, people buy less bread and the weight of the PCE curve decreases while the CPI curve does not change.
How do asset classes respond?
Deyfus Banquiers explains what inflation means for the financial markets for the three asset classes equities, bonds and currencies.
Equities: These develop particularly well when inflation is moderate and stable because uncertainty is low and corporate profits are easy to predict. Sudden price increases, on the other hand, are a risk to operating margins because increased production costs, if and to what extent, can usually only be passed on with a delay.
Higher inflation rates force central banks to adopt more restrictive monetary policies with higher interest rates, causing stock values to shrink due to rising discount rates. In addition, the measures taken to combat inflation are blurring the growth prospects and increasing the pressure on equities. The commodity sector and companies that can quickly pass on rising production costs are preferable in these circumstances.
Equities and inflation
bonds with a fixed coupon and predefined redemption at maturity (par value) are highly dependent on changes in inflation. The fixed interest payments reflect the inflation expectations at the time of issue and are not adjusted subsequently, even if market conditions change. As inflation accelerates, the discounted future coupons and redemptions are worth less today, causing the bond price to fall. The longer the remaining term of the bond, the greater the loss.
Inflation Linked Bonds (TIPS) provide protection against rising inflation. The nominal value is linked to the realized inflation and thus guarantees a real return that is independent of inflation.
Inflation and bonds
Currencies: The theory of purchasing power parity says that the exchange rate between two currencies is in equilibrium when the purchasing power of both countries is the same. This means that the exchange rate must correspond to the ratio between the two countries’ price levels for a fixed basket of goods and services. As a country’s domestic price level rises, the currency should become cheaper to return to equilibrium.
In the long run, currencies tend to adjust their exchange rates to the respective inflation differentials. In the short term, however, it is economic data and financial market impacts such as monetary policy and interest rate differentials that drive exchange rate developments.