There’s been a lot of talk about inflation lately. While inflation, at its most basic, is an increase in prices, there are differences in the way that it is measured. You should pay attention to inflation, since it represents an erosion of your buying power. However, it does help to know how policymakers view inflation. It will give you a better idea of how to plan your finances more effectively. Two measures of inflation that you should pay attention are CPI and core inflation.

CPI

The measure that is most often used to measure inflation in terms of consumers is the consumer price index (CPI). Tens of thousands of items, in several categories, are tracked. The basket of products of services is considered each month, and economists and statisticians look for trends. If the CPI rises, it is an indication that prices could be trending higher, with inflation on the rise.

Core Inflation

There is some controversy surrounding the use of CPI as a reliable measure of inflation. However, there might be even more controversy surrounding the use of core inflation in setting monetary policy. The Federal Reserve, when it sets its benchmark interest rate and makes monetary and economic policy, considers the effects of inflation. While members of the Fed might consider CPI, core inflation is more frequently mentioned in policy announcements.

Core inflation is basically CPI, but with the most volatile items broken out. Core inflation doesn’t include food and energy prices. As a result, some argue that the use of core inflation actually hurts more than it helps, since rising food and energy prices are more likely to significantly impact the household budgets of most consumers. You probably already know that food and energy prices often rise faster than other items — and they are prices likely to significantly impact your pocketbook.

Tracking Your Own Inflation Trends

Instead of relying on the government to tell you what’s happening with inflation, you can actually track inflation on your own. Take a look at what you normally spend money on. Choose a certain day each month to check the prices of these items and create your own measure. You can watch your personal inflation index for trends in prices. If you use public transportation, gas prices aren’t going to figure heavily into your personal inflation measure. If you have a  newborn, and need to buy diapers, that measure will be an important part of your personal inflation measure.

You can compare your personal inflation measure to CPI and to core inflation. This will give you an idea of how accurate — how “real” — the wider statistics are for you. As you plan your finances, remember to consider the effect that inflation will have. The inflation rate will erode your returns. If you’re earning 6% annually, but prices rise at 3% a year, you are only earning 4%. If your portfolio earns less than the rate of inflation, you are actually losing money in real terms.

Whether you follow CPI, core inflation or use your own measure, you should pay attention to inflation. This will allow you to make decisions about what investments will help you beat inflation.

You may have heard the word stagflation before, but do you know what it is? Stagflation is a word penned from combining stagnation and inflation, and was first used in 1965 by a British politician by the name of Lain Macleod. He warned of a time when this could occur, where the inflation rate was higher than the rate of economic growth.

Relationship Between Unemployment and Inflation

At the time of Mr. Macleod’s statement, the United States was still going through a post war boom, and the government believed that the relationship between unemployment and inflation was stable and did not think there was anything to be worried about. A charting system called the Philip’s Curve showed that generally, as unemployment went down, inflation went up, and vice versa. So the government decided to boost the demand for goods and services while keeping unemployment low, thinking that this would create a safely rising inflation rate. Unfortunately though, this backfired on them. At first workers expected a higher pay due to the inflation rate and employers generally complied to this, but as the inflation rate got out of hand, workers didn’t want to work harder for less wages, and unemployment rose, while inflation was still rising as well.

Oil Embargo

This unbalanced relationship between wages and prices was not the only thing that caused the stagflation, however. In 1973, OPEC’s oil embargo raised oil prices to levels not seen before. This affected prices at the gas pumps and in various U.S. industries, and caused a lot of fuel shortages. From 1970 through 1979 the inflation rates continued to rise at exorbitant rates not seen before, and this time period also saw a halt to the stock market.

Government Spending and Borrowing

The federal government and President Carter tried several ways to bring stabilization back to the country, including a lot of government spending and borrowing, plus putting guidelines on wages and prices. These tactics only seemed to make matters worse. It took until 1979, when federal chairman Paul Vocker started raising interest rates, cutting the flow of money going to the economy. It caused high unemployment and a recession in the 1980’s, but eventually things evened out again, once again bringing the economy to a stable level.

Current Troubles

This past November in 2010, the Federal Reserve launched the latest stimulus, called QE2. The reason stated for this was that without more stimulation, the country could go into a period of falling prices. But instead this stimulus has caused global inflation, and some experts fear that this could put the U.S. into another time of stagflation. Other countries such as China are already seeing the results of the global inflation, with rioting breaking out in several major cities. With the already rapidly rising costs for fuel and food, some see a similar time in the U.S. to the period during the 1970’s, and believe we will have to brace ourselves for another stagflation. Some experts, however, say a stagflation is not possible because of the high unemployment rate since in order for it to be a true stagflation, employment would be high and rising along with the inflation.

What’s your thoughts?  Should we be worried about staglation?

photo credit: illustir

Many of my clients (and me included) have been concerned about the expected rise of inflation. The problem is that we’ve been concerned for a few years and thus far, inflation has been a non-concern. What seems to be the new concern is deflation. Where deflation isn’t a typical concern for the average consumer, it has been a topic of concern for consumers and the Federal government at large for many years. Journalist Dave Carpenter refers to deflation as “Deflation is the potential new boogieman for consumers, replacing inflation.” So what exactly is this new boogieman? It is defined as the declining of prices of goods and services over time. Deflation is the direct opposite of inflation and occurs for one or more of the following reasons:

• The supply of money decreases
• The supply of other goods increases
• The demand for money increases
• The demand for other goods decreases

When Does Deflation Occur

Typically, deflation will occur when the supply of goods increases faster than the supply of money on hand. A good example of deflation can be explained using the advancement of technology. Years ago, personal computers cost a fortune because the technologies back then didn’t allow for an abundance of products to be on the market. Remember how much you paid for a computer 10 years ago? Over time, technology has advanced so much that the supply of computers increased at a faster rate than the demand for money, causing the prices of computers to drop drastically over the years. Now you can go to Wal-Mart and buy a mini laptop for a fraction of the cost.

Deflation is a natural part of the economy. When deflation occurs, the available amount of currency falls for each person, making money harder to come by but yet giving it more purchasing power. Consumers then pay less for goods and services. It may sound advantageous to get more power with every dollar but deflation also heightens the issue of debt because after a significant time of deflation, payments being made towards a debt represent an increased amount of money than when the initial debt was incurred.

The Bad Side of Deflation

There are a number of reasons to be concerned or at least aware of deflation. When consumers continually expect falling prices, they are less willing to spend or borrow money. This situation can depress the economy which allows the deflation cycle to continue. This leads to less jobs and a smaller cash flow for businesses and individual consumers. Additionally, deflation can spark higher interest rates, making credit less affordable and reduces activity and demand in the economy.

Should You Be Concerned About Deflation?

photo credit: B Rosen

The symptoms of deflation can be a detrimental to an individual especially if they are left without a job and by definition have not traditionally been savers. Consumers are directly involved in the health of the US economy and when faced with a period of deflation, it is not solely the Federal government who must step in to the rescue. Spending money to stimulate the economy is just as necessary as the government’s responsibility to keeping money in stock.

During the Great Depression in the 1930’s, the Federal Reserve allowed the money supply to shrink by 35%. Consumers could not afford to buy products or services, and businesses could not sell what they were producing. Jobs were difficult to come by. The Federal Reserve is currently placing its focus on the declining demand for goods, the decrease in prices, and lowered wages. The government has not looked this closely at deflation since 2003 and there is concern we are not out of the woods just yet.

sources:

http://www.msnbc.msn.com/id/38822584/ns/business-personal_finance/

photo credit: James Jordan

Inflation The Next Concern?

Dear Clients and Friends:

Too much good news can be bad news—at least that is how the markets see it.

The recent string of better than expected economic data is consistent with the rapid pace of healing in the credit markets—the key driver of the recession. In fact, last week marked the 12th week that the financial indicators LPL Financial Research uses to evaluate the overall health of the economy have shown steady improvement. The data increasingly paints a picture of a still weak, but rapidly improving U.S. economy.  However, this news isn’t being interpreted as all good by the markets.

Here’s Inflation

Market participants’ concerns are shifting from a potential lengthening and deepening of the recession to inflation that might be stoked by a rapid recovery. In the past, high and rising inflation has proven to be a far harder problem to solve than a weakening economy in recession.  Now that the economy is beginning to gain traction, the issue is becoming how quickly and effectively policymakers will rein in stimulus to avoid inflation. The uncertainty of the timing and effectiveness of the Fed’s response—and concerns that action pulling back the stimulus too soon could tip the global economy back in to a second downturn—are weighing on investors’ confidence.

We believe there will be substantial inflation in raw material prices.  However, we expect only a modest rebound in prices for finished goods, measured by the traditional gauge of inflation—the Consumer Price Index, given abundant labor and factory capacity around the world that will take years to absorb.  We do not believe the Fed will move aggressively due to the lack of significant inflation in finished goods prices and the risk of undermining the improvement in the banks, credit markets, and the economy.

Good news still is good news

—after all, the economy is improving and the stock and corporate bond markets have rebounded sharply from of the lows of early March. It is increasingly likely that the worst of the financial crisis is behind us. However, the better performance has resulted in some risks.  For instance, the combination of higher mortgage rates and higher gasoline prices could pose a threat to the recovery if these trends continue unabated. As a result, volatility may return to the markets over the coming months.  We stress the importance of a commitment to your long-term investment strategy. As always, please contact me if you have any questions.

Sincerely,

Jeff Rose, CFP®

This research material has been prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

Worried About Inflation

This report was prepared by my firm LPL Financial.

Last week’s key economic data came in better than expected, including the closely watched ISM report gauge of manufacturing activity, auto sales, and employment. This string of better than expected numbers is consistent with the rapid pace of healing in the credit markets—the key driver of the recession. Last week marked the 12th week of improvement in the LPL Financial Current Conditions Index. Important gauges of stress in the credit markets are back to pre-crisis levels; the TED spread, a key measure of interbank liquidity, is back down to a relatively normal 0.50%. On Friday, the employment report reflected a net job loss of 345,000 for the United States in the month of May, far less than forecasted and only half the loss reported four months earlier for January. May’s job loss was the smallest since the crisis began with the failure of Lehman Brothers and the seizure in the credit markets in mid-September of last year. The data increasingly paint a picture of a still weak, but rapidly improving U.S. economy.

Good news?

This is not the way the markets are viewing it. On Friday, the best employment report in eight months failed to inspire a rally. In fact, stocks, bonds, and commodities fell. The S&P 500 Index slipped 0.3% to 940. The yield on the 10-year U.S. Treasury note jumped to 3.83%—rebounding to levels that preceded the crisis. Commodity prices, measured by the Commodity Research Bureau Index, fell 0.7%. Market participants’ concerns are shifting from a potential lengthening and deepening of the recession to the inflation that might be stoked by a rapid recovery.

Presented with evidence of more rapid improvement than expected in the economy and key drivers of growth, market participants’ worries have quickly shifted to what policy actions may follow. Governments around the world are still in stimulus mode. Central banks around the word continue to cut interest rates and provide capital to banks to promote lending. Government spending programs continue to be announced around the world, and here in the United States, the vast majority of the $787 billion stimulus package passed earlier this year has yet to be spent and remains in the pipeline. However, now that the economy is beginning to gain traction, the issue is becoming how quickly and effectively policy makers will rein in stimulus to avoid inflation. In the past, high and rising inflation has proven to be a far harder problem to solve than a weakening economy in recession. In fact, it often requires a recession to curb accelerating prices. With Fed rates currently set near zero, federal funds futures contracts show market participants expect the Fed will hike rates to 0.50% by November. The expected rate nearly doubled on Friday after the release of the data on the labor market. The uncertainty of the timing and effectiveness of the Fed’s response—and concerns that action to rein in stimulus too soon could tip the global economy back in to a second downturn—are weighing on investors’ confidence.

What about Inflation?

We believe there will be substantial inflation in raw material prices, but only a modest rebound in prices for finished goods measured by the Consumer Price Index. Indeed, we are already seeing raw material prices soar. Over the past few months, the prices of many commodities have soared 25-50%, including the four C’s: crude oil, copper, cotton, and coffee. However, raw material prices alone are unlikely to push up prices for finished goods for several reasons. Raw material prices are a relatively small portion of the cost of most goods or services while labor makes up the vast bulk of the cost. The world has abundant excess labor and factory capacity. Inflation is not usually a problem until excess capacity is absorbed and wages begin to rise. Presently, wages are not reflecting upward pressure and are unlikely to do so for some time.

The power of excess labor capacity and low wage growth to limit prices can be most easily seen by looking back just a few years. Following the bursting of the tech bubble, the Fed lowered interest rates to a record low, credit was being created through the rapidly increasing leverage in the financial system, raw material prices were soaring (led by oil prices), and the dollar was falling. Yet outside of food and energy commodities, the United States did not experience much inflation. Fed chairman Ben Bernanke was nominated by Bush and began his four year term in 2006. President Obama is likely to replace him with a Democrat when his term is up in early 2010. This likelihood adds to the uncertainty surrounding the Fed’s response to the improvement in conditions and threat of inflation. We believe the Fed will not move aggressively and risk undermining the improvement in banks, credit markets, and the economy. It is too early to determine whether inflation is a likely to be a big problem for investors in late 2010 or 2011 as excess capacity may begin to be absorbed. However, investors can take steps now to both seek a profit and protect from rising prices.

IMPORTANT DISCLOSURES

• The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• Investing in international and emerging markets may entail additional risks such as currency fl uctuation and political instability. Investing in small-cap stocks includes specifi c risks such as greater volatility and potentially less liquidity. Stock investing involves risk including loss of principal Past performance is not a guarantee of future results. Investing in alternative investment may not be suitable for all investors and involve special risks such as risk associated with leveraging the investment, potential adverse market forces, regulatory changes, potential liquidity. There is no assurance that the investment objective will be attained.
• Small-cap stocks may be subject to higher degree of risk than more established companies’ securities. The illiquidity of the small-cap market may adversely affect the value of these investments.
• Alternative investment mutual fund strategies are subject to increased risk due to the use of derivatives and/or futures.