Econ Category #4: Prices & Inflation

 

“Making anything artificially cheap usually means that it will be wasted,
whatever that thing might be and wherever it might be located”  

– Thomas Sowell

 

Howdy, gang! I trust that all is well with you and yours. It’s been an interesting month in the markets (and economy), which means that it’s been optimal for learning. In my opinion, when things are acting abnormally it gives us an opportunity to step back and observe. That observation is transformed into experience, which is something you can’t acquire through books and blogs. Experience has to be experienced, right? I encourage you to take advantage of the things that are going on (and will continue to go on) by taking a step back and observing. Ask yourself questions; pay attention to the actions/reactions of the markets; and keep working towards your goals. I believe that you’ll find yourself on a much more sturdy ground down the road if you keep challenging yourself during periods of tumult, uncertainty, and change.

In the previous installments of Know Good Things, we have been attempting to categorize economic reports in an effort to help make things more understandable and organized. If you’ve ever tried to incorporate macroeconomic analysis into your personal trading routine then you have probably noticed that there are quite a number of reports to keep track of. Hopefully, this series of creating economic categories will help slow things down for you.

• The first category was Output, Income, and Spending; (read it HERE)
• The second was Employment and Wages;(read it HERE & HERE)
• The third was Production and Business Activity. (read it HERE)

In each of these individual blog submissions, I attempted to label the typical reports found in the respective category as either Procyclic, Countercyclic, or Acyclic… As well as Leading, Lagging, or Coincident. It might not be a bad idea to go back and review the blogs that detailed these various classifications and labels because it really will help with your ability to implement proper analysis if you have a solid understanding of the types of reactions that individual reports tend to have on the markets.

This week’s category involves INFLATION, which is something we better get a familiarity with. I’ve held the personal opinion (for some time now) that inflationary data has been skewed over the past decade for political purposes. It’s hard for me to swallow the notion that The Federal Reserve has been creating trillions of dollars in order to purchase our own debt, yet that practice has not had an impact on inflation. I kind of have a hard time with that, which is just an opinion. My opinion, however, doesn’t move the markets! The data that we are given is what motivates institutions and individuals into making market related decisions so I tend to keep my opinions to myself because they really don’t matter. I am well prepared because of my opinions, however. When things ultimately change (for better or worse) I am usually not surprised and ready to react accordingly. Such is the value of being literate regarding macroeconomics…but I digress.

Inflation is the general increase in prices and subsequent decrease in the purchasing power of money. Since the dismissal of the “Gold Standard” (beginning with FDR’s domestic economic policies and ending with Nixon’s official declaration), inflation of our currency has been rather constant. It hasn’t been as bad as other countries and other economies, but it hasn’t been ideal, either. When inflation increases we are all essentially getting saddled with a pay cut because we simply can’t stretch our money as far as we once could. Inflation affects businesses differently than individuals, too. When a business notices an increase in the cost for raw materials then they simply increase the sales prices and pass it off to the consumer. They may not sell as much after the price increase because consumers won’t be able to afford as much, but that’s just part of the process.

There are really just two major economic reports that fit in this category, but a handful of others still exist. The “other” reports that would fit into this category simply don’t receive enough attention to really worry about. A report like “Prices Received and Paid by Farmers”, for example, doesn’t make headlines and is not widely paid attention to. I still think there’s value in staying up-to-date with the data from that report (issued monthly; coincident; procyclical) because there’s an obvious cause-and-effect relationship between agriculture prices and consumer wealth, but I would still put much more emphasis on the two main reports, which are:

• Producer Price Index (PPI) [monthly]

• Consumer Price Index (CPI) [monthly]

These measures are all measures of changes in the price level and thus measure inflation. Inflation is COINCIDENT and a PROCYCLICAL economic indicator.

Of these two reports, the CPI usually gets the most attention. It (CPI) is a pretty basic report and is used to gauge how much change in the purchasing power of consumer (people like you and me). A basket of goods are rounded up and priced then they repeat this process the following month with the same goods and compare the price variance. The change is then reported in the Consumer Price Index each and every month. Just imagine if you bought a loaf a bread, gallon of milk, package of cheese, diapers, and toothpaste each and every month. You would assume that the total price you ended up paying would be the exact same each and every month because you aren’t changing the quantity or the brand. That assumption would be a folly, as you are likely well aware. Since the prices of raw materials change from time to time, the final sales price will also change.

The Producer Price Index is essentially the same type of report except that it only looks at raw materials purchased by businesses that are needed to produce their products. Businesses are surveyed (the same businesses each month) and asked to report on their costs for materials. The change in the prices they are reporting is then issued in the PPI each and every month. Personally, I tend to focus on the PPI a little bit more than the CPI because is acts as a leading indicator for consumer inflation. If businesses are paying more for their raw materials then it’s safe to assume that a price increase is forthcoming.

Inflation is yucky. It’s unfortunate. It affects us all, but it certainly affects some people more than others. It’s unlikely that a 3% increase in inflation will affect a millionaire the same way it will affect a middle-class worker with three kids. Since there are many, many more middle-class workers as there are millionaires, the economy (as a whole) usually suffers if inflation rises too much, too quickly. The real pain, however, is when companies are unable to give their employees an annual “cost of living” increase in salary. When wages remain unchanged during a period where inflation increases (usually an average of 2% to 3% per year) then we will likely NOT see any economic expansion…growth. Such was the case for a large part of the previous decade following the recession of 2009.

The markets don’t respond well to inflation, as you can imagine. So, paying attention to these reports along with some of the other important reports will keep you prepared for “unexpected economic variances”. While other traders are panicking and reacting emotionally, you are calm. You’ve planned for this. You’ve prepared yourself.
Best of luck, my friends! Keep working hard and, as always: Be good. Do good. Know good.

 

Be good.  Do good.  Know good.

Kleiny (@KnowGoodThings)

Columbus, Indiana