Rising inflation can be really detrimental to the economy, which is why this is something that is constantly monitored by the Fed.
When you’re dealing with stock trading and investing, you will inevitably talk about rising inflation. It is a perpetual concern for shoppers and consumers since it reduces their power to buy, but it also affects how much manufacturers and sellers can earn from what they sell, since their raw materials and production processes also end up becoming more expensive. Inflation refers to the rise in the average price level of a set of goods and services over a particular time period.
Rising Inflation Raises Cost of Living and Stifles the Economy
With rising prices, the public is faced with a higher cost of living. When they struggle to buy stuff because they are priced more, businesses and markets selling them suffer since their earnings are compromised. That affects their stocks too since investors are apprehensive of these stocks’ earning potential. The whole economy struggles. That’s why the country’s monetary authority, the Fed in the United States, intervenes to ensure inflation is within sane levels. It is essential for keeping the economy in good health.
You measure inflation depending on the particular kind of goods or services dealt with. When the inflation rate sinks below 0%, you have what is called a deflation which is just the opposite of inflation. Deflation is where prices fall. Significant deflation is also detrimental to the concerned industry since the businesses get less for the goods or services they sell. But let’s stick to inflation for now and understand more about it.
In a word, the basis of inflation is price rise. But there are various factors that cause the price to rise. Investopedia primarily attributes this to three factors:
This inflation occurs as a result of the goods’ and services’ demand in the economy rising faster than the economy is able to produce. The demand is high but the capacity to produce goods and services to meet that increased demand is less. This results in a gap between demand and supply. The most common international example is when OPEC (Organization of the Petroleum Exporting Countries) decides to reduce oil production by its member countries. As production is reduced, supply reduces as well. Reduced supply increases its deficit to consumer demand. That causes the oil prices to rise, which affects the other business sectors of the economy as well, contributing to overall inflation.
Now there is also another contributory factor here, which is money supply. Increased money supply results in inflation. When there is more money printed by the country’s monetary board and more given to individuals, they have a lot more purchasing power. The overall consumer sentiment is positive, resulting in greater spending across all sectors. Reducing the currency’s value, also known as devaluing, also leaves people with a lot of money around but with lesser power to purchase as a result of their money holding much lesser value than it used to.
Cost-push inflation happens when you have a rise in the prices of inputs and resources that contribute to produce goods and offer services. If the raw material for manufacturing a product rises, the production cost of the product increases too. The manufacturer then has to sell the product at a higher cost to cover the reduced profit. We discussed the rise in oil prices. When oil prices rise, they lead to increased costs of transportation of raw materials to the factory since trucks and vehicles all run on diesel which is a petroleum product. The transportation industry gets directly affected by the oil price rise, but it trickles down to the other sectors of the economy as well.
Built-in inflation is caused by inflation itself. Inflation raises the expectations of the labor force. When you have overall price rise in the economy, the labor force in businesses and organizations demands more wages so that they can maintain their cost of living. When companies pay more wages to their staff, the production costs of their goods and services rise and cause further inflation. It’s a vicious cycle.
Calculating Inflation with Indices
Inflation is commonly calculated with the help of CPI (Consumer Price Index) and WPI (Wholesale Price Index). CPI measures the weight price average of a section of goods and services that primarily deal with consumer needs. This includes food, medical care and transportation. The prices considered are the retail prices for each product as available for individual citizens to purchase. CPI has been calculated right from 1913 by the United States Bureau of Labor Statistics. CPI changes can help assess cost of living. That’s why this index is most commonly used to identify inflation and deflation periods.
The WPI measures price changes in goods before they get to the retail market. The WPI goods usually include items at the wholesale market and raw materials required at the manufacturer level. This in an index followed internationally, but in the United States the PPI (Producer Price Index) is used which is more or less similar to the WPI. The PPI measures prices changes from the seller’s perspective unlike the CPI that measures the price changes from the consumer’s perspective.
Why Rising Inflation Is Bad
When inflation keeps rising, the prices of resources and raw materials go higher, resulting in higher prices for the finished products. The value of currency reduces, since you can buy much less with the same amount of money after the inflation. That reduces the purchasing power of consumers, meaning they buy less stuff. The lesser purchasing overall coupled with higher cost of producing goods and services causes the profit margins of the companies to come down as a result of reduced revenues. This spreads throughout the markets, resulting in the whole economy slowing down till it reaches a state of steadiness. In rising inflationary periods, it is important to have the ability to quickly trade in and out of companies. TradeZero provides direct market access execution for free to its members.
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