The Importance Of Inflation And GDP

Investors are likely to hear the terms inflation and gross domestic product (GDP) just about every day. They are often made to feel that these metrics must be studied as a surgeon would study a patient's chart prior to operating. Chances are that we have some concept of what they mean and how they interact, but what do we do when the best economic minds in the world can't agree on basic distinctions between how much the U.S. economy should grow, or how much inflation is too much for the financial markets to handle? Individual investors need to find a level of understanding that assists their decision-making without inundating them in piles of data. Find out what inflation and GDP mean for the market, the economy and your portfolio. Terminology Before we begin our journey into the macroeconomic village, let's review the terminology we'll be using. Inflation Inflation can mean either an increase in the money supply or an increase in price levels. Generally, when we hear about inflation, we are hearing about a rise in prices compared to some benchmark. If the money supply has been increased, this will usually manifest itself in higher price levels - it is simply a matter of time. For the sake of this discussion, we will consider inflation as measured by the core Consumer Price Index (CPI), which is the standard measurement of inflation used in the U.S. financial markets. Core CPI excludes food and energy from its formulas because these goods show more price volatility than the remainder of the CPI. GDP Gross domestic product in the United States represents the total aggregate output of the U.S. economy. It is important to keep in mind that the GDP figures as reported to investors are already adjusted for inflation. In other words, if the gross GDP was calculated to be 6% higher than the previous year, but inflation measured 2% over the same period, GDP growth would be reported as 4%, or the net growth over the period. The Slippery Slope The relationship between inflation and economic output (GDP) plays out like a very delicate dance. For stock market investors, annual growth in the GDP is vital. If overall economic output is declining or merely holding steady, most companies will not be able to increase their profits, which is the primary driver of stock performance. However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable. Most economists today agree that 2.5-3.5% GDP growth per year is the most that our economy can safely maintain without causing negative side effects. But where do these numbers come from? In order to answer that question, we need to bring a new variable, unemployment rate, into play. Studies have shown that over the past 20 years, annual GDP growth over 2.5% has caused a 0.5% drop in unemployment for every percentage point over 2.5%. It sounds like the perfect way to kill two birds with one stone - increase overall growth while lowering the unemployment rate, right? Unfortunately, however, this positive relationship starts to break down when employment gets very low, or near full employment. Extremely low unemployment rates have proved to be more costly than valuable, because an economy operating at near full employment will cause two important things to happen:

1.

Aggregate demand for goods and services will increase faster than supply, causing prices to rise.

2.

Companies will have to raise wages as a result of the tight labor market. This increase usually is passed on to consumers in the form of higher prices as the company looks to maximize profits.

Over time, the growth in GDP causes inflation, and inflation begets hyperinflation. Once this process is in place, it can quickly become a self-reinforcing feedback loop. This is because in a world where inflation is increasing, people will spend more money because they know that it will be less valuable in the future. This causes further increases in GDP in the short term, bringing about further price increases. Also, the effects of inflation are not linear; 10% inflation is much more than twice as harmful as 5% inflation. These are lessons that most advanced economies have learned through experience; in the U.S., you only need to go back about 30 years to find a prolonged period of high inflation, which was only remedied by going through a painful period of high unemployment and lost production as potential capacity sat idle. "Say When" So how much inflation is "too much"? Asking this question uncovers another big debate, one argued not only in the U.S,. but around the world by central bankers and economists alike. There are those who insist that advanced economies should aim to have 0% inflation, or in other words, stable prices. The general consensus, however, is that a little inflation is actually a good thing. The biggest reason behind this argument in favor of inflation is the case of wages. In a healthy economy, sometimes market forces will require that companies reduce real wages, or wages after inflation. In a theoretical world, a 2% wage increase during a year with 4% inflation has the same net effect to the worker as a 2% wage reduction in periods of zero inflation. But out in the real world, nominal (actual dollar) wage cuts rarely occur because workers tend to refuse to accept wage cuts at any time. This is the primary reason that most economists today (including those in charge of U.S. monetary policy) agree that a small amount of inflation, about 1-2% a year, is more beneficial than detrimental to the economy. The Federal Reserve and Monetary Policy The U.S. essentially has two weapons in its arsenal to help guide the economy toward a path of stable growth without excessive inflation; monetary policy and fiscal policy. Fiscal policy comes from the government in the form of taxation and federal budgeting policies. While fiscal policy can be very effective in specific cases to spur growth in the economy, most market watchers look to monetary policy to do most of the heavy lifting in keeping the economy in a stable growth pattern. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) is charged with implementing monetary policy, which is defined as any action to limit or increase the amount of money that is circulating in the economy. Whittled down, that means the Federal Reserve (the Fed) can make money easier or harder to come by, thereby encouraging spending to spur the economy and constricting access to capital when growth rates are reaching what are deemed unsustainable levels. Before he retired, Alan Greenspan was often (half seriously) referred to as being the most powerful person on the planet. Where did this impression come from? Most likely it was because Mr. Greenspan's position (now Ben Bernanke's) as Chairman of the Federal Reserve provided him with special, albeit un-sexy, powers - chiefly the ability to set the Federal Funds Rate. The "Fed Funds" rate is the rock-bottom rate at which money can change hands between financial institutions in the United States. While it takes time to work the effects of a change in the Fed Funds rate (or discount rate) throughout the economy, it has proved very effective in making adjustments to the overall money supply when needed. (To continue reading about the Fed, see Formulating Monetary Policy, The Federal Reserve and A Farewell To Alan Greenspan.) Asking the small group of men and women of the FOMC, who sit around a table a few times a year, to alter the course of the world's largest economy is a tall order. It's like trying to steer a ship the size of Texas across the Pacific - it can be done, but the rudder on this ship must be small so as to cause the least disruption to the water around it. Only by applying small opposing pressures or releasing a little pressure when needed can the Fed calmly guide the economy

along the safest and least costly path to stable growth. The three areas of the economy that the Fed watches most diligently are GDP, unemployment and inflation. Most of the data they have to work with is old data, so an understanding of trends is very important. At its best, the Fed is hoping to always be ahead of the curve, anticipating what is around the corner tomorrow so it can be maneuvered around today. The Devil Is in the Details There is as much debate over how to calculate GDP and inflation as there is about what to do with them when they're published. Analysts and economists alike will often start picking apart the GDP figure or discounting the inflation figure by some amount, especially when it suits their position on the markets at that time. Once we take into account hedonic adjustments for "quality improvements", reweighting and seasonality adjustments, there isn't much left that hasn't been factored, smoothed, or weighted in one way or another. Still, there is a methodology being used, and as long as no fundamental changes to it are made, we can look at rates of change in the CPI (as measured by inflation) and know that we are comparing from a consistent base. Implications for Investors Keeping a close eye on inflation is most important for fixed-income investors, as future income streams must be discounted by inflation to determine how much value today' money will have in the future. For stock investors, inflation, whether real or anticipated, is what motivates us to take on the increased risk of investing in the stock market, in the hope of generating the highest real rates of return. Real returns (all of our stock market discussions should be pared down to this ultimate metric) are the returns on investment that are left standing after commissions, taxes, inflation and all other frictional costs are taken into account. As long as inflation is moderate, the stock market provides the best chances for this compared to fixed income and cash. There are times when it is most helpful to simply take the inflation and GDP numbers at face value and move on; after all, there are many things that demand our attention as investors. However, it is valuable to re-expose ourselves to the underlying theories behind the numbers from time to time so that we can put our potential for investment returns into the proper perspective.

What Impact of inflation and GDP on stock market returns in India? Inflation is a state in the economic climate of a country, when there is a cost increase of products as well as solutions. To meet the required cost increase, people have to invest more than is assumed. With increase in inflation, every industry of the economic climate is impacted. Including lack of employment, costs, forex costs, investment, inventory marketplaces, there is an consequences of inflation in every industry. Blowing up is limited to impact all groups, either immediately or in a roundabout way. Blowing up and currency marketplaces have a very close connection. If there is inflation, inventory marketplaces are the worst impacted. Prices of shares are determined by the net income of a organization. It depends on how much profit, the organization is likely to make in the lengthy run or the near future. If it is believed that a organization is likely to do well in the years to come, the inventory values of the organization will increase. On the other hand, if it is noticed from styles that the organization may not do well in the lengthy run, the inventory values will not be higher. In other words, the cost of shares are immediately proportionate to the performance of the organization.In the event when inflation improves, the organization income (worth) will also decrease. This will detrimentally affect the inventory values and eventually the comes back.Effect of inflation on currency marketplaces is also obvious from the fact that it

improves the costs if attention. If the amount of inflation is higher, the amount is also higher. In the awaken of both (inflation and attention rates) being higher, the financial institution will often cover for the development of costs. Therefore, the person has to acquire of a loan at better pay. This performs a significant role in barring funds from being spent in inventory marketplaces.When the government has enough finance circulation available that you can buy, the cost of products, solutions usually go up. This leads to the loss of the purchasing power of people. The value of money also reduces. In a nut spend, for the economic climate to succeed, inflation and currency marketplaces ought to be more contouring and foreseen. In economics, inflation is a rise in the common stage of costs of products or solutions in an economic climate over some time interval. When the common cost range goes up, each device of currency buys fewer products or solutions. Consequently, inflation also reflects erosion in the purchasing power of cash a loss of actual value in the internal medium of exchange and device of account in the economic climate. A chief measure of cost inflation is the amount of inflation up, the annualized amount change in a common cost catalog eventually. Inflations results on an economic climate are various and can be at the same time good and bad. Side results of inflation up involve a decrease in the actual value of cash and other financial items eventually, concern over upcoming inflation up may discourage financial commitment and savings, and high inflation up may lead to shortages of products if consumers begin hoarding out of concern that costs will improve at some point. Results involve ensuring central banks can adjust nominal rates and encouraging financial commitment in non-monetary capital projects. Inflation occurs when the cost range goes up from one interval to the next. The amount of inflation up expresses the improve in amount terms. The statistic of the cost range is a trial and, therefore, so is the statistic of the amount of inflation up. A catalog that held excellent constant, according to this view, would show a lesser amount of cost improve from season to season, and thus a lesser average amount of inflation up.