Macro-Economic Trading

Understanding Inflation

Remember when we learned in science class that an object already in motion will continue in motion unless acted upon by some external force. This law is Newton’s second law of motion. A similar law holds for inflation. Most economists believe that there is a core inflation rate that is present until some kind of shock comes along to change things. Embedded in the idea of core inflation, is the concept of inflationary expectations. Inflationary expectations are important because it becomes a self fulfilling prophecy since expectations of inflation can contribute to actual inflation. Inflationary expectations strongly influence the behavior of businesses, investors and consumers.

For example, as an operations manager at a large conglomerate, if I strongly believe can affect productivity increases of 2 percent over the next year. In addition, if the inflationary expectations are 3 percent for the next year, come review time, I will ask for a minimum salary increase of 5 percent. I assume, as most people do, that inflation will continue to be what it already is – this is called adaptive expectations.

Up until about 1960, inflation was largely viewed as a demand-pull phenomenon. Whenever there was a general rise in prices, it was typically attributed to excess aggregate demand – too much money chasing too few goods. According to the Keynesian thought, this could be fixed using contractionary fiscal or monetary policies.

Cost-push (supply shock) inflation is very much feared by the Fed because this supply side shock will cause both inflation and recession. This is the deadly economic disease know as stagflation. Contrast this with demand pull inflation, there is no simply Keynesian policy solution to cost-push inflation.

One of the reasons why Alan Greenspan is treated like a rock star is rooted in his actions in the year 2000. The Fed was fighting both cost-push and demand pull inflation. When the OPEC cartel began raising oil prices sharply, the economy was suddenly faced with rising energy prices. Interestingly, Alan Greenspan was smart enough to realize that OPEC was helping the Fed to do its job by bringing the economy under control. In this case higher oil prices worked the same way as contractionary fiscal policy in the form of higher taxes. As oil prices rose, consumers had less money to spend on other goods being produced in other sectors of the economy. This means, the Fed could be less aggressive about raising interest rates to fight demand-pull inflation.

The Fed is very likely to raise interest rates when demand-pull inflation is the driving force behind the inflation phenomenon. However, they are less likely to raise rates when supply side shocks like rising energy prices are creating cost-push inflationary pressures.

Wage Inflation

Wage inflation is more likely to occur in the latter stages of an economic recovery, usually as a result of demand-pull pressures. Here, labor unions, smelling green, will likely see their bargaining power rise to a maximum. Large wage increases paid to union workers, will ripple through the wider economy. As labor markets in the non-union sectors get tighter and tighter, firms will begin to bid against each other for workers hence driving up the cost of labor.

Don’t be misguided, as wage inflation can also be driven by cost-push pressures. When the economy was fighting stagflation in the 1970s, many labor unions negotiated the inclusion of cost of living adjustment clauses into their contracts. As cost-push inflation soared, wages were driven up leading to higher prices, fewer sales and more layoffs.

Any sign of wage inflation will be met with a very strong response from the Fed and in-turn, the market will react harshly. Both the Fed and the Street know that wage inflation typically occurs in the advanced stages of the inflationary cycle and will require the strongest medicine to cure.

The major inflation indicators are important to watch – these are the Consumer Price Index (CPI), the Producer Price Index (PPI), the GDP deflators, average hourly earnings, and the Employment Cost Index.

The Consumer Price Index (CPI)

The CPI is a very important gauge of inflationary pressures. It is probably the most closely watched of all the major inflation indicators. Any unexpected changes in the CPI will have a major impact on both the stock and bond markets. The data is released by the Department of Labor between the 15th and the 21st of every month. The data is released at 8:30 a.m. EST before the market opens, as is the case with most economic indicators.

The CPI measures inflation at the retail level. To put things in perspective, most traders are very careful to analyze the CPI without food and energy. Let’s say the CPI (without food and energy) is increasing, this means that demand-pull inflationary pressures are building and the Fed is more likely to raise rates.

The Producer Price Index

If the CPI measures inflation at the retail level, then the Producer Price Index or PPI measures inflation at the wholesale level. The data are released around the 11th of each month for the prior month by the Department of Labor. The PPI is actually three indexes instead of one. The first PPI reflects prices of crude materials such as grains, livestock, oil and raw cotton. A second PPI reflects prices of partially processed intermediate foods such as flour, leather, auto-parts. The third PPI looks at finished goods such as bread, shoes, autos and clothes. It is the finished goods PPI that gets the attention of most traders – Wall Street and Main Street.

The GDP Deflators

The GDP deflators are the broadest measure of inflation. They cover price changes for over 500 items in every sector, from consumer products and capital goods to foreign imports and the government sector. The deflators – a chain price index, a fixed weight deflator and an implicit deflator are reported quarterly and are considered lagging indicators. They do not generate a lot of interest from traders because of the above reasons.

Pages: 1 2 3 4 5 6 7