Macro Fundamentals Explained — Part II
Macro Fundamentals Explained — Part II
In the second part of our Macro Fundamentals Explained series, we will have a closer look at everybody’s favorite: the Inflation factor.
What is Inflation
Inflation refers to the increase in prices of goods and services within an economy over a specific time period, typically expressed as a percentage. For example, if inflation is 2%, it means that prices, on average, have risen by 2% compared to the previous period. This implies that if a bottle of water cost $1 last year, it would now be around $1.02. Inflation can have significant implications for an economy as it reduces the purchasing power of individuals.
What is Deflation
Deflation is the opposite of inflation, where prices decrease. This suggests weak demand for goods and services and often leads to low interest rates. Deflation is uncommon among developed countries.
Stagflation and Hyperinflation
Stagflation occurs when an economy experiences stagnant or low growth while inflation persists. This can happen when external factors, such as the price of oil, impact the economy.
Hyperinflation refers to an extremely high rate of inflation within an economy. It can be caused by an excessive increase in the money supply, leading to heightened consumer spending and higher demand for goods and services.
Both deflation and hyperinflation can be detrimental to an economy, resulting in higher unemployment rates and reduced growth. Hence, the role of central banks in controlling inflation becomes crucial to maintain stability and prevent destructive consequences.
Measuring Inflation
There are various economic data sets that give us insight into inflation.
Consumer Price Index (CPI):
The Consumer Price Index (CPI) is a commonly used method to measure inflation. It calculates inflation based on a basket of goods and services, often known as a “cost-of-living index.” Common cost-of-living indexes include CPI and Retail Price Index (RPI). These measures reflect the inflation experienced by consumers in their daily lives. Each central bank faces unique challenges in selecting the appropriate items to include in their inflation calculation.
Core CPI and Headline CPI:
Two frequently used terms when discussing inflation are “core” and “headline” CPI. The difference between the two is straightforward. Core CPI excludes food and energy prices from the Consumer Price Index, while headline CPI includes both food and energy prices.
Producer Price Index (PPI):
The Producer Price Index (PPI) focuses on inflation at the early stages of domestic production, providing crucial information for manufacturers and industries. The PPI is generally more volatile than other measures, which can be attributed, in part, to producers being unable to fully pass on cost increases to consumers during challenging periods, such as the global financial crisis.
CPI vs. PPI
The PPI covers all marketable output sold by domestic producers to the personal consumption sector of the economy. The majority of this output comes from the private sector, although the government also produces some marketable goods within the PPI’s scope. In contrast, the scope of the CPI includes goods and services provided by businesses or the government when explicit user charges are assessed and paid for by consumers.
The most significant component in the All Items CPI is owners’ equivalent rent, which contributes approximately 24 percent to the overall index. Owners’ equivalent rent represents the hypothetical rent that owner occupants would have to pay if they were renting their homes and is included in the CPI to reflect the cost of shelter for owner-occupied housing units. The PPI does not include owners’ equivalent rent because it is not a domestically produced, marketable output.
The treatment of imports also differs between the PPI and the CPI. The CPI includes imports within its scope as it covers goods and services purchased by domestic consumers. On the other hand, the PPI does not include imports since they are not produced by domestic firms. Imports make up a significant portion of the CPI, especially in components such as apparel and new cars, leading to a substantial disparity between the two indices.
Another distinction between the PPI and the CPI lies in the components included based on payment responsibility. The PPI incorporates components of personal consumption that are not directly paid for by consumers. For example, it includes medical services paid for by third parties like employers, insurance companies or the federal government. In contrast, the CPI only includes payments made directly by consumers for medical care.
A final difference in scope is related to services that involve interest rate components. The CPI excludes changes in interest rates or interest costs from its scope. Although the CPI includes services like banking and insurance, which have an interest rate component in their prices, the interest rate itself is not factored into the index. The PPI’s scope, however, encompasses services with an interest rate component, and the index includes the impact of interest rates on their prices. Banking services account for approximately 4% of the PPI, and insurance services make up 3.8%. Changes in interest rates affect the price indexes for banking and insurance within the PPI. While the CPI covers some banking services, such as ATM fees, and many insurance services, it does not include the interest rate component. Consequently, changes in interest rates do not impact the CPI.
Source: United States Department of Labor
Source: United States Department of Labor
GDP Price Deflator:
Another method to measure inflation is through the GDP price deflator, which considers only domestic goods, while CPI also includes imported goods. Another key difference is that the GDP deflator encompasses all goods and services, whereas CPI only measures the price of goods and services purchased by consumers. The GDP deflator has an advantage of not being restricted by a fixed basket of goods.
GDP Deflator = (Nominal GDP/Real GDP) x 100
Each measure of inflation has its own unique characteristics that may be suitable for different purposes. There is no definitive “best” way to calculate inflation, as each measure offers distinct aspects that cater to specific requirements and applications.
Source: The World Bank
Causes of Inflation
Inflation can arise through various channels, either individually or in combination. Here are some of the main sources of inflation that can affect any nation worldwide:
Exchange Rates
When the local currency weakens, more of it is needed to purchase imports. This increased cost is then passed on to consumers, contributing to inflation.
Essential Commodity Prices
Many manufacturers rely on inputs, such as commodities like iron ore or oil, to produce goods. If the prices of these inputs rise, the higher costs can be passed on to consumers, resulting in inflation.
Interest Rates
Lower interest rates can stimulate consumer spending, leading to increased demand and higher prices of goods. This, in turn, can lead to inflation, assuming other factors remain constant.
Government Debt
Rising government debt can raise concerns about the possibility of a government default. As a result, yields on treasury securities increase to compensate potential investors for the higher risk. This, in turn, requires more tax revenue to be allocated to interest payments on government debt obligations, reducing living standards. To offset the reduced government spending, businesses may raise prices for goods and services, contributing to inflation.
The aforementioned sources generally fall into two broad categories of inflation:
Demand-Pull Inflation
This type of inflation occurs when aggregate demand increases, including from households, governments, foreign buyers, and businesses.
There are five primary causes of demand-pull inflation:
Growing economy: When consumers feel confident, they spend more and take on more debt. This leads to a steady increase in demand, which means higher prices.
Increasing export demand: A sudden rise in exports forces an undervaluation of the currencies involved.
Government spending: When the government spends more freely, prices go up.
Inflation expectations: Companies may increase their prices in expectation of inflation in the near future.
Excess money in the system: An expansion of the money supply with too few goods to buy makes prices increase.
Cost-Push Inflation
Inflation driven by cost-push factors arises from pressures on the supply side. When production costs rise, leading to a decrease in supply, the result is higher prices for consumers.
Causes of cost-push inflation:
An increase in the prices of input goods used in manufacturing, such as raw materials, can lead to cost-push inflation. For instance, if companies utilize copper in their manufacturing processes and the metal’s price suddenly rises, companies may pass on these higher costs to their customers.
Rising labor costs can also contribute to cost-push inflation. This can occur when mandatory wage increases are implemented for production employees, such as due to a rise in the minimum wage. Additionally, a worker strike resulting from stalled contract negotiations can lead to reduced production and subsequently higher prices.
Unexpected causes of cost-push inflation often stem from natural disasters, such as floods, earthquakes, fires, or tornadoes. If a major disaster damages a production facility and disrupts the production chain, increased production costs are likely to follow. In such cases, companies may have no choice but to raise prices in order to recoup some of the losses incurred.
Other events that can lead to higher production costs include sudden changes in government that affect a country’s ability to maintain its previous level of output. These types of government-induced increases in production costs are more commonly observed in developing countries.
Government regulations and changes in laws, although usually anticipated, can also cause costs to rise for businesses. In such cases, businesses may struggle to compensate for the increased costs associated with these regulations.
Impacts of Inflation
Value of Money
From a consumer perspective, the most evident consequence of inflation is the increased cost of goods and services. This effectively diminishes the value of money, as individuals can purchase fewer goods and services with the same amount of money compared to a period of lower inflation.
Wealth Inequalities
Unequal distribution of inflationary pressures among individuals can lead to shifts in wealth. For instance, individuals with loans during times of high inflation may benefit as the real value of their debt repayments decreases over time, while others may not experience the same advantage.
Inflation Volatility
Fluctuating or unpredictable inflation rates complicate business operations, as companies struggle to set prices. This can have a negative impact on the economy, as both businesses and consumers must adjust to the higher inflation rates. Long-term business agreements may also incur higher costs due to volatile inflation, which increases the risk premium on hedging expenses and can reduce foreign investor confidence.
Implementation of Inflation Targets by Central Banks
Inflation targeting involves central banks setting specific inflation goals in percentage terms through monetary policy adjustments. This approach provides clarity to both central banks and the public regarding future expectations. The objective of inflation targeting is to achieve price stability, as price stability can be maintained by controlling inflation.
A common inflation target range of 1% — 2% allows for some flexibility for governments and central banks. Deviations beyond 1% on either side of the target are usually seen as concerning and may require policy intervention.
Approaches Governments Utilize to Manage Inflation
Governments employ various methods to control inflation, which can have positive or negative effects on the economy depending on the prevailing economic conditions. The most commonly used approach is contractionary monetary policy, which is implemented by central banks to reduce inflationary pressures by tightening liquidity.
This is accomplished through three main avenues:
1. Decreasing Money Supply
Reducing the money supply limits the amount of money consumers have available for spending, thus helping to curb inflation. One way to achieve this is by increasing the interest rates on sovereign bond payments, which attracts more investors to purchase bonds.
2. Reserve Requirements
Imposing restrictions on the amount of money that banks must hold as reserves can influence the lending capacity of banks. If banks are required to maintain higher reserve levels, they will have less money available for lending. This, in turn, can reduce consumer spending and consequently curb inflation.
3. Raising Interest Rates
Increasing interest rates discourages borrowing and leads to decreased spending. There is also a higher opportunity cost of investing capital in businesses due to the potential for higher returns in the capital markets.
Closing Remarks
In the second part of our series, we highlighted the extensive implications of inflation. Inflation serves as a significant economic factor in macroeconomics, and understanding its dynamics can be instrumental in formulating effective trading strategies, as inflation data has the potential to drive price movements in various financial markets.
That’s it for this week. Next week we will have a closer look at retail sales and consumer sentiment.
Written by: Gunter L.
