Investors may come across the concepts of inflation and gross domestic product on a daily basis. Most investors have a basic understanding of GDP and inflation. Still, it cannot be easy to know what to do when the world’s top economists cannot agree on basic differences about the amount of growth the US economy should see or just how much prices are becoming too high for the financial markets to absorb.
Finding a level of knowledge that supports your decision-making without overloading you with pointless information is essential for becoming a successful investor. Learn how gross domestic product (GDP) and prices affect the economy, the market, and your portfolio.
What is Inflation?
Inflation can be defined as either an increase in the money supply or a rise in prices. A price increase in relation to a benchmark is what is meant to be understood when one speaks of inflation. It’s only a matter of time till prices rise to show that the amount of cash available has been growing.
In the United States stock market, the conventional measure of inflation is the fundamental Consumer Price Index (CPI). The core inflation measurement is more significant. Food and energy are not included in the foundation CPI’s formulas because their prices change more than those of the other CPI items.
What is Gross Domestic Product (GDP)?
The country’s gross domestic product represents the whole aggregate output of the American economy. Please be aware that the GDP figures provided to investors have already been adjusted for inflation. Put another way, GDP growth, or the amount of net growth over the period, would have to be reported at 4% if the gross GDP was estimated to be 6% higher than the previous calendar year. Still, inflation was only determined to have been 2% during that same period.
The Relationship between Inflation and GDP
The relationship between GDP (economic output) and price increases is delicate, akin to a dance. For investors in the company’s stock market, annual GDP growth is essential. As profits are the main factor influencing stock performance, most companies are going to need more money to raise theirs if the overall economic output is, in two ways, declining or staying the same.
However, excessive GDP growth is also risky because it will almost certainly lead to higher inflation, which reduces the value of our money and future earnings from companies, destroying stock market gains.
Where are these figures coming from?
We must use the rate of unemployment as a new variable in order to provide an answer to that query. According to studies, for every one percentage point above 2.5% in the average annual GDP increase over the last 20 years, there has been a 0.5% decrease in unemployment.4 It seems like the ideal way to accomplish two goals at once—lower the rate of unemployment and boost overall growth.
Sadly, though, this beneficial relationship begins to deteriorate when employment falls extremely low or approaches full employment. Very low unemployment rates have turned out to be more expensive than beneficial since they will lead to two important results in an economy that is close to full job opportunities:
● Prices will rise as a consequence of a faster-than-expected increase in aggregate demand for products and services.
● The tight labor market will compel businesses to raise wages. In order for the business to maximize profits, this increase is typically passed on to customers in the form of increased costs.
Inflation occurs due to GDP growth over time. If inflation is not controlled, it can turn into hyperinflation. After this procedure is established, it can easily turn into a feedback loop that reinforces itself. This is a result of people spending more money in an environment where inflation is on the rise because they anticipate that it will lose value over time. In the short term, this ends up resulting in further GDP growth, which raises prices further.
Moreover, inflation has nonlinear effects. Put differently, the damage caused by 10% inflation is more than twice that of 5% inflation. Most industrialized nations have learned the lessons above the hard way; look back a few decades in the United States to find a protracted period of high inflation that was only ended by suffering through a difficult period of high unemployment and lost output as potential capacity sat idle.
Calculating GDP and Inflation
Just as much discussion surrounds the proper way of determining GDP and inflation compared to what is regarding what should happen to these numbers once they are released. Analysts and economists often choose to analyze the GDP figure or adjust the inflation figure by a specific percentage based on their position in the markets at that particular moment.
There are few elements left that haven’t undergone some form of adjustment, smoothing, or weighting, considering hedonic modifications for “quality improvements,” re-weighting, and seasonality adjustments. However, by examining the rates of change in the CPI (as measured by inflation), we can ensure that we are making comparisons from an identical starting point, provided there are no significant alterations to the methodology.
Reasons Why Investors Must Keep An Eye on Inflation
For fixed-income investors, monitoring price increases closely is especially crucial because the future value of today’s money is contingent upon discounting potential revenue streams by inflation. The incentive for stock investors to assume the heightened risk of investing in the stock market, with the goal of achieving the highest real rates of return, arises from either actual or anticipated inflation.
The returns on investment that remain after commissions, taxes, inflation, and other frictional costs are deducted are known as real returns, and they are the ultimate measure. In contrast to fixed income and cash, the stock market offers the greatest opportunities for real returns, so long as price increases are moderate.
Is GDP a Reliable Inflation Calculator?
Although GDP growth frequently causes inflation to rise, GDP is not the most accurate indicator of inflation. This holds true because the GDP measures the total economic output of a nation. Furthermore, real GDP measures more than just inflation, even though it does. The Consumer Price Index serves as a more accurate measure of inflation.
Is GDP Greater When Prices Are Higher?
Increased inflation typically has minimal to no impact on GDP since wages generally rise in tandem with prices. Higher inflation, according to a number of economists, actually lowers GDP. In a similar vein, higher GDP growth reduces inflation if more is produced, which raises supply, lowers demand, and lowers prices. Instead, slow economists prefer steady and predictable inflation.
Who Is Advantaged By Inflation?
While all dislike rising costs, some individuals do profit from inflation. For instance, when the value of money declines, borrowers stand to gain because the amount of cash they have borrowed is essentially less “expensive” to return. Homeowners gain as well because as prices rise, their house’s value increases.
Sometimes, particularly when there are so many other things that need your focus as an investor, it is best to accept the GDP and inflation figures at their actual value and move on. To put your potential for returns on investments in the right context, it is helpful to review the fundamental ideas that underlie the numbers periodically.