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What is Inflation?

What is Inflation?

What is inflation and what does it measure? Inflation measures the rate at which prices increase for consumer goods and services. Inflation also measures the rate at which a currency’s purchasing power declines. If consumer goods and services are getting more expensive, then inflation is rising. As inflation rises, the relevant currency’s purchasing power declines. As prices increase, the amount a consumer can purchase with one unit of currency decreases.

Inflation Information

Inflation is a consistent increase in the general level of prices in an economy. The inflation rate is a measure of this phenomenon.

What causes inflation? Many economists point to an increase in the rate of growth of the money supply in an economy as the primary culprit. In comparison, others point to sudden changes in aggregate demand and aggregate supply, following a Keynesian approach to macroeconomic analysis.

Inflation Rate Example

For example, let’s take the price of a can of soda. Let’s say last year a can of soda cost $1.00. And let’s say the inflation rate for the past 12 months is 5%. We could then assume the cost of a can of soda today is $1.05. The price has gone up by 5%. The dollar’s purchasing power has gone down – one dollar is no longer enough money to buy a can of soda.

Inflation Measures

There are two important inflation measures in the U.S. They are the headline inflation rate and the core inflation rate. In addition, these inflation rates are published monthly by the U.S. Bureau of Labor Statistics.

The headline inflation rate, also called the consumer price index (CPI), measures the rate at which prices are rising for a wide selection of consumer goods. Headline inflation is designed to measure the rate at which cost of living expenses increase over time.

The core inflation rate is the headline inflation rate but without food and energy prices. Food and energy prices are considered more volatile than other consumer prices. Therefore, some consider it important to view the inflation rate excluding these two components.

There are a variety of other approaches to estimating the inflation rate, such as calculations based off of the US Producer Price Index (PPI) and the US Gross Domestic Product (GDP Deflator).

Inflation and Monetary Policy

Most central bank’s have a target inflation rate. For example, the U.S. central bank, the U.K. central bank, and the European Central Bank prefer to keep inflation at around 2%. A nation’s central bank can use certain monetary policy tools to influence inflation. These includes the following:

  • Foreign exchange market intervention
  • Open-market operations
  • Adjusting the reserve requirement ratio
  • Adjusting key interest rates.

Central banks often implement monetary policy tools to influence the inflation rate towards the target inflation rate.

Market Intervention

Foreign exchange market intervention refers to a central bank buying or selling currency in the open market in order to influence the nation’s money supply. Increasing the money supply devalues the currency and increases inflation. Whereas, decreasing the money supply appreciates the currency and decreases inflation. Ergo, a nation’s central bank can purchase currency in the open market to fight inflation.

Open Market Operations Definition

Open-market operations refer to a central bank buying or selling government securities. Buying government securities increases the money supply and spurs inflation. But selling government securities decreases the money supply and curbs inflation. Therefore, a nation’s central bank can sell government securities to fight inflation.

Reserve Requirement Ratio

The reserve requirement ratio is the amount of cash a commercial bank must hold relative to the value of its customer deposits. For example, if a bank receives customer deposits totaling $100, and the reserve requirement is 10%, then that bank must always have at least $10 cash on hand. A central bank can either increase or decrease the reserve requirement ratio for the nation’s commercial banks, thereby decreasing or increasing the domestic money supply. Furthermore, increasing the reserve requirement curbs inflation, decreasing the reserve requirement spurs inflation.

Key Interest Rates

Central banks can also raise or lower key interest rates in an effort to influence inflation. In the U.S., the central bank’s key interest rate, the fed funds rate, is the rate at which banks lend to each other overnight. Raising the interest rate can reduce the money supply, damp economic activity, and curb inflation. But lowering the key interest rate can increase the money supply, stimulate the economy, and increase inflation. A central bank can raise interest rates to fight inflation.

Inflation Protection

When faced with the threat of rising inflation, which can erode the value of investment returns, investors may seek investments that are protected from inflation. One option is to invest in U.S. Treasury Inflation Protected Securities (TIPS).

TIPS are U.S. Treasury securities that are protected against inflation. The coupon payments and the principal value automatically adjust according to the headline inflation rate. This protects investors from the negative effects inflation can have on investment returns. The downside is that TIPS offer a comparatively low interest rate.

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See Also:
Economic Indicators
Consumer Price Index
Supply and Demand Elasticity
The Feds Beige Book
Z-Score Model

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Wholesale Prices Continue to Rise

According to the US Department of Labor’s Producer Price Index (PPI), wholesale prices increased for the seventh consecutive month in January.

Per Bloomberg, the proximate cause were the prices of crude oil and other raw commodities. Producers are expected to be able to pass along these price increases to their customers, though the Federal Reserve does not expect these price increases to result in a marked increase in consumer price inflation.

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Fed Official Warns of Inflation Risk

Per WSJ.com:

“A top Federal Reserve official Tuesday warned that any move by the central bank to reduce unemployment could lead to inflation, indicating he would oppose any further policy easing by the Fed to try and boost U.S. economic growth.

Richmond Federal Reserve President Jeffrey Lacker told Bloomberg in an interview the central bank is keeping a close eye on inflation, especially now that the U.S. economy is gaining speed and global food and energy prices are surging.

“I am not sure we can push unemployment that much further down or more rapidly without risking inflation picking up,” Lacker said…”

Link

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Construction Costs Are Going Through the Roof

Sorry, I couldn’t resist the pun! Recently I have been visiting with several general contracting clients regarding the challenges they are facing. Both complained of the dramatic rise in construction costs in the face of a softening economy. Over the past 6 months construction costs have been increasing 1% – 2% per month for an annualized inflation rate of 12% to 20%.

What It Means For Construction Costs

These increases have made it difficult to manage the budgets for their projects. Projects that were awarded 6 months ago have seen dramatic price increases in almost every area. Steel prices, as we mentioned, have seen the most dramatic increase. In some projects the steel component has increase 50% over the past six months.

But that is not the only area. Equipment rental, PVC pipe (made from petrochemical feedstock), copper wiring and other basic material have all seen increases. Finally, delivery costs to get the material to the job site have followed the price of gasoline.

So how are they managing the situation? One strategy is to lock in their subs prices within seven days of being awarded the contract. One contractor notified the sub on the eighth day and received a price increase of $20,000. He later negotiated it back down to $2,000 (which he couldn’t pass on to the customer.)

Other strategies include negotiating price increases with customers or factoring in modest price increases in their original bid. Either way it will be interesting to see how rising replacement cost vs falling demand affects real estate values.

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Steel Prices Fuel Inflation

You have probably been reading in the news about the resurgence of inflation. Have you wondered what was driving the return to higher inflation? One of the most insidious driver is steel prices. You don’t buy it directly, but, it affects everything you buy.

Over the past six months scrap steel prices have increased 100% to 180%. Pipe and tube prices have risen 40% to 100%. What are the drivers causing this dramatic run up in prices at a time that the US is going into a recession?

A major factor is the industry consolidation of iron ore/ scrap producers and the steel producers themselves. This factor coupled with the weak dollar results in strong pricing power on the part of the manufacuturers. The foreign producers can’t import steel at competitive prices so the domestic manufacturers can increase prices with out much threat.

Finally, because of the strong international growth world wide demand for steel is at an alltime high. This results in domestic steel producers exporting more product oversees.

So when is this situation going to end? The answer: not any time soon. Until the dollar strengthens or the world economy slows we will be competing for a scarce commodity with the developing countries.

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Interest and Inflation

Today, we’re looking at interest and inflation. Per the Bureau of Labor Statistics, the rate of inflation in the prices of consumer goods and services was roughly 4.5% from December of 1996 to December of 1997. Yet the Federal Reserve, which up until a few months ago was mightily concerned about such inflation, has now set its federal funds rate target at 3.5%.

Interest and Inflation

The Fed publicly stated last week that it expected “inflation to moderate in coming quarters”. Given the extent to which the dollar has sunk in value relative to most major, if not all, global currencies so far this century, in no small part thanks to the Fed itself, one must contemplate just how much this newfound indifference to inflation will continue.

In the near term, the Fed may be able to keep short rates low, with another rate cut expected this week to be announced after the FOMC meeting. But eventually those rates should start to creep up.

So what does this mean for you? If perhaps you are considering seeking debt financing, between now and June may be the time to lock in a decent rate before the Fed is forced to do the obvious and begin to raise the fed funds target rate to deal with inflation and the continuing weakness in the dollar. But be mindful that we might be headed into an economic slowdown in which emergency Fed actions and dead cat bounces in the equity markets can mask no longer.

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