The most popular measure of inflation is the increase in consumer prices over a 12-month period. When one reads in the newspaper that inflation is 2.7%, it means that the consumer price index, which will be discussed in greater detail later in this section, has risen 2.7% in the previous 12 months. Investors need to follow closely the trend in inflation. To do so, they need to compare the current growth in consumer prices versus what it was a month ago, two months ago, and three months ago, and so on. Later on in this book, we’ll provide ample background on how to predict the trend of inflation.
Inflation is a very important measure to follow because the economy and financial markets thrive during times of declining or low inflation (below 3%). Years when inflation is rising are characterized by extreme volatility of the economy and the financial markets. This is not only true for the U.S. economy, but also for any economy around the globe - from Latin America to Europe and Asia. As it has been shown conclusively by Milton Friedman, inflation is solely and exclusively a monetary phenomenon. In other words, inflationary pressures depend on the monetary policy followed by the Fed. In Chapter 6 we will discuss in great detail how central banks can impact the inflation of a country.
From an investment viewpoint, changes in inflation impact the financial markets and asset prices in different ways. Declining inflation is favorable to stocks and bonds. However, rising inflation makes real estate, precious metals, and other hard assets more attractive than stocks and bonds.
Commodity prices are probably the most sensitive and meaningful indicator about future trends in inflation. Commodities are raw materials to be used in the production of goods. These are commodities such as:
• Grains and feeds (examples in these sectors are barley, wheat, and corn)
• Commodities classified as foods (in this category: beef, broilers, butter, cocoa, eggs, ham, hogs, pork and steer)
• Fats and oils, such as coconut meats, coconut oil, coconut palm, lard, soy bean and tallow
• Oil, which includes different types of crude oil, domestic crude grades and refined products
• Fibers and textiles – such as burlap, cotton and wool
• Metals, including aluminum, copper, lead, steel scrap, tin and zinc
• Precious metals, such as gold, silver, platinum, and palladium
• Miscellaneous commodities such as rubber and hides
All these commodities are used in the production of goods and the change in price of these commodities provide very useful information on trends of the economy. Most of these commodities tend to follow the same trend most of the time. This seems to be difficult to accept. However, when the economy is strong, demand increases across the board of the commodity spectrum.
There are two types of commodity prices. One type of price is called spot price and the other one is the price of futures. In the spot market a commodity is priced for immediate delivery. In the futures market a commodity is priced for delivery at a future date. For instance, the price of oil for delivery in a month is different from the price of oil for delivery in two months, three months, and so on. The difference for all these prices is market conditions, storage costs, interest rates and transportation costs.
Spot prices of industrial materials are the first ones to respond to acceleration or deceleration in manufacturing and overall business activity. Since it is difficult to analyze all these commodities one by one, to make the process of analysis simpler, analysts have established indices in groups of commodities that have the same functions: grains, foods, fats, fibers and textiles, precious metals.
The most popular index of these commodities is the CRB Index, which consists of two indices: the CRB for spot prices and the CRB for futures prices. The CRB index for spot prices is an index that reflects the price of the components of the spot level, while the CRB index for futures reflects the futures price of the components. The CRB industrial materials index (spot and futures) can be found on the website of Bridge/CRB daily.
Commodity prices reflect the judgment of the marketplace, the strength of the economy, and the inflationary policies of the Fed. An overall strengthening of the commodity market reflects the fact that the economy is very strong and the increase in the commodity prices will eventually be passed on by the producers of goods to the final consumer. An increase in commodity prices has an inflationary implication. Under these conditions investors should expect upward pressure on short-term and long-term interest rates. This is the main reason why commodity prices provide crucial information for the investor. By closely watching the trends in commodities, the investor can begin to think about the possibility or rising interest rates and the tightening of monetary policies, which will be discussed in great detail in Chapter 6. Of course such trends greatly impact the risk in investing in stocks and bonds.
Other important gauges of inflation are gold and crude oil prices. Although crude oil prices have much more volatility than gold, due to the fact that they are controlled by a cartel, the basic trends and turning points are the same. It is always a good assumption to believe that all commodities follow the same trend. It is very difficult, for instance, to see an increase in gold prices without an increase in copper prices or crude oil prices. Or to put it in a different way, a strong move in copper without sharply rising gold prices or other commodities would make the increase in copper suspect. The reason is that commodity prices are driven by the strength of the economy and when the economy is strong, all commodities rise. On the other hand, when commodities are weak, investors should expect weak commodities.
The importance of following many commodities and indices is that they all tend to rise in the same direction when inflationary pressures are rising and are strong. The more commodities rise, the higher the risk of rising inflation. If most commodities decline, the outlook for inflation is benign.
Another indicator which is important to follow to determine inflationary pressures is wages. Wages usually accelerate when the unemployment rate declines and stabilizes, meaning that the labor market is tight. These are also times when unemployment claims are low.
Acceleration in wages, as we will see in the next section, is not necessarily inflationary, because increases in productivity absorb increases in wages. In fact, this is exactly what you want to see in a strong economy. The ideal situation is to experience wages growing at a 3-4% pace and productivity expanding at the same rate. In these conditions, labor costs (wages adjusted for productivity) is zero and wages are not inflationary. However, if productivity growth is zero, labor costs adjusted for productivity rise at a 3-4% pace and this is clearly inflationary. Information about wages and productivity is released by the Bureau of Labor Statistics.
The producer price index provides information on the pricing power of producers and manufacturers of goods. There are several measures released by the Bureau of Labor Statistics: the producer price index for finished goods; semi-finished goods - that is goods that need further processing; and producer prices of raw materials. The producer price index is a family of indices that measure the average change over time in the selling prices received by domestic producers of goods and services.
The producer price index (PPI) measures price changes from the prospective of the seller. This contrasts with other measures, such as the consumer price index (CPI), that measures price change from the purchasers’ prospective. Sellers and purchasers’ prices may differ, due to government subsidies, sales and excise taxes and distribution costs. Over ten thousand PPIs for individual products and groups of products are released each month. PPIs are available for the products of virtually every industry in the money, mining, and manufacturing sectors of the U.S. economy. New PPIs are gradually being introduced for the products of industries in the transportation, utilities, trade, finance and service sectors of the economy.
Producer price index data are widely used by the business community as well as the government. The three major uses are:
1. As an economic indicator. The PPIs capture price movements prior to their retail level. Therefore, they may foreshadow subsequent price changes for businesses and consumers. The President, Congress and the Federal Reserve employ this data in formulating fiscal and monetary policy.
2. As a deflator of other economic series. PPIs are used to adjust other economic information for price changes to translate those data into inflation-free dollars. For example, constant dollar gross domestic product is estimated using deflators based on PPI data.
3. As a basis for contract escalation. PPI data are commonly used in escalating purchasing and sales contracts. These contracts typically specify dollar amounts to be paid at some point in the future. It is often desirable to include escalation clauses that account for increases in input prices. For example, a long-term contract for bread may be escalated for changes in wheat prices by applying the percent change in the PPI for wheat to the contracted price for bread.
While both the PPI and the consumer price index measure price change over time for a fixed set of goods and services, they differ in two critical areas: 1) the composition of the set of goods and services, and 2) the type of prices collected for the included goods and services.
The target set of goods and services included in the PPIs is the entire marketed output of U.S. producers. The set includes both goods and services purchased by other producers as inputs to their operations or as capital investments, as well as goods and services purchased by consumers either directly from service producers or indirectly from retailers. Because the PPI target is the output of U.S. producers, imports are excluded.
The target set of items included in the CPI is the set of goods and services purchased for consumption purposes by urban U.S. households. This set includes imports. The producer price index, as its name suggests, is an index and as such is a tool that simplifies the measurement of movements in a numerical series. Movements are measured with respect to the base period when the index is set to 100. An index of 110, for example, means that there has been a 10% increase in prices since the base period. Similarly, an index of 90 indicates a 10% decrease. The typical way of expressing the increase in producer price index, for analysis purposes, is done by comparing the index of this month to the index for the same month twelve months ago.
It is used by comparing the rate of change over twelve months. The formula used is dividing the current month by the same month a year ago, subtracting to the result one, and then multiplying the outcome by 100.
The turning points of all these measures take place at the same time. When one of those indices slows down, they all slow down. The difference is in their volatility. Changes in producer prices of crude materials are much more volatile than producer prices of semi-processed goods and changes in producer prices of finished goods.
A broad measure of inflation, the one that we all relate to, is the consumer price index. The consumer price index (CPI) is a measure of the average change over time in the prices paid by consumers for a market basket of consumer goods and services. The CPI provides a way for consumers to compare the change in prices of the market basket of goods and services.
The consumer price index affects nearly all Americans because of the way it is used. Three major uses are, 1) as an economic indicator, 2) as deflator of economic series, and 3) as means of adjusting dollar values. The CPI reflects spending patterns of the population. It is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed, and retired persons, as well as urban wage earners and clerical workers.
Not included in the CPI are the spending patterns of persons living in rural, non-metropolitan areas, farm families, persons in the armed forces and those institutions such as prisons and mental hospitals. The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. The CPI represents all goods and services purchased for consumption by the referenced population. The Bureau of Labor Statistics has classified all expenditure items in more than 200 categories arranged into eight major groups. Major groups and examples of categories in each are as follows.
1. Food and beverages (breakfast cereal, milk, coffee, chicken, etc.)
2. Housing (rent of primary residences, owners equivalent rent, fuel oil, etc.)
3. Apparel (men’s shirts and sweaters, women’s dresses, etc.)
4. Transportation (new vehicles, airline fares, gasoline, etc.)
5. Medical care (prescription drugs, medical supplies, physician services, etc.)
6. Recreation (television, cable television, pets and pet products, etc.)
7. Education and communication (college tuition, postage, telephone services, etc.)
8. Other goods and services (tobacco and smoking products, haircuts, etc.)
Also included within these major groups are various government user fees, such as water and sewerage charges, auto registration fees and vehicle tolls. The CPI also includes taxes that are directly associated with the prices of specific goods and services. However, the CPI excludes taxes such as income and social security taxes not directly associated with the purchase of consumer goods and services. The CPI does not include investment items, such as stocks, bonds, real estate, and life insurance.
For each of the more than 200 item categories, the Bureau of Labor Statistics has chosen samples of several hundred specific items within selected business establishments frequented by consumers using scientific statistical procedures to represent thousands of varieties available in the marketplace. Each month the Bureau of Labor Statistics data collectors visit or call thousands of retail stores, service establishments, rental units or doctors’ offices all over the United States to obtain price information on thousands of items used to track and measure price changes in the CPI.
The CPI index, like the producer price index, is used to compare the current level of the index to a given reference point. So, if the index is 115, and the reference index is 100, that means that prices have increased 15% over the reference time. The most useful way of measuring the CPI index is to compare the rate of change over 12 months, which is computed by taking the value of the index this month divided by the value of the index the same month a year ago, subtracting one to the result of the ratio, and then multiplying the outcome by 100. By making this computation every month, one can chart the trend in inflation every month.
The Bureau of Labor Statistics also produces specialized indices and the most common one is core inflation, which is the CPI excluding the change in prices of food and energy. The reason analysts like this index is because the core inflation index is less volatile because the two elements like food and energy provide great volatility to the overall index itself.
Acceleration in the consumer price index indicates that inflation is increasing. The consumer price index reflects the price of a basket of goods and services, which are bought by the typical consumer. It is not unusual to see commodity prices accelerating ahead of an acceleration in consumer price index. On the other hand, a sharp decline in commodities of a few months is an indication that the economy is weakening and that the growth in consumer price index will soon decline. Information on the consumer price index is available from the Bureau of Labor Statistics.
The National Association of Purchasing Managers releases data on prices paid by purchasing managers. This index oscillates around 50. Inflationary pressures are strong when more than 50% of the purchasing managers report that they are paying higher prices. When this index falls below 50, it is an indication that the risk of higher inflation is decreasing and inflation is being brought under control.
This information is very useful for investors. If the odds favor rising inflation, it is also true that there is a strong probability that interest rates will rise, pointing to higher risk for the financial markets. On the other hand, a decline of the index below 50, since it provides an indication that inflation is subsiding, suggests that interest rates are likely to decline, thus providing a favorable environment for stocks and bonds.
Finally, the Bureau of Labor Statistics releases the employment cost index on a quarterly basis. This index reflects trends in both wages and benefits paid to workers, and it represents the most comprehensive figure of labor costs. The importance of following the rate of change in the employment cost index is twofold. First, an acceleration or rising growth in the employment cost index means that the labor costs for corporations and businesses is increasing. Therefore, business will try to pass this increased cost to consumers. An increase in the rate of change in the employment cost index is likely to be reflected in higher inflation rates. The employment cost index is important because an increase in this index means that labor costs for business is increasing, suggesting that the profitability for businesses is under downward pressure, and when margins decrease, business can only react by cutting costs and increasing layoffs.
The employment cost index has importance as an inflation indicator, and therefore, is a gauge that will point to the direction of interest rates and also has importance in the fact that it signals a downward pressure on the profitability of business. Inflationary pressures arise only after the economy is growing rapidly. They are reflected by an increase in the growth of commodity prices, in rising growth in producer price index and consumer price index, with the price index of the National Association of Purchasing Managers moving decidedly above 50. During such times of rising inflation, the growth in the employment cost index is also rising. Declining trends in inflation are found after the economy has been slowing down for some time, commodity prices are declining, the change in producer price index and consumer price index are declining, and the price index of the National Association of Purchasing Managers is declining below 50. During these times, the growth in the employment cost index is also declining.
(From Chapter 2 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).
George Dagnino, PhD Editor,
The Peter Dag Portfolio.
2009 Market Timer of the Year by Timer Digest
Disclaimer.The content on this site is provided as general information only and should not be taken as investment advice nor is it a recommendation to buy or sell any financial instrument. Actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.
Shouldn't you too subscribe to The Peter Dag Portfolio?