Information on Inflation that you should be aware of
Inflation is defined as a steady increase in the general level of prices for goods and services over a sustained period of time. It is expressed as a percentage increase in the Consumer Price Index (CPI), which is generally prepared on a monthly basis by the U.S. Bureau of Labor Statistics and measures annual percentage increases in consumer prices.
With an increase in inflation, purchasing power diminishes, fixed-asset values are impacted, companies adjust their pricing of goods and services, financial markets react, and the composition of investment portfolios is altered as a result.
Inflation, in some form or another, is an unavoidable fact of life. Any increase in the price of goods and services has an impact on consumers, businesses, and investors. The purpose of this article is to provide an overview of the different aspects of the investing process that are affected by inflation, as well as to show you what you need to be aware of.
Financial Reporting and the Fluctuation of Market Prices
While working on “inflation accounting” between 1979 and 1986, the Financial Accounting Standards Board (FASB) required companies to include supplemental constant dollar and current cost accounting information (which was not audited) in their annual reports.
The guidelines for this approach were laid out in Statement of Financial Accounting Standards No. 33, which asserted that “inflation causes historical cost financial statements to show illusionary profits and mask erosion of capital,” and that “inflation causes historical cost financial statements to show illusionary profits and mask erosion of capital.”
SFAS No. 33 was quietly rescinded in 1986, with little fanfare or outpouring of opposition. Serious investors, on the other hand, should have a reasonable understanding of how shifting prices can affect financial statements, market environments, and investment returns.
Financial Statements of a Corporation
Property, plant, and equipment are all classified as fixed assets on a balance sheet, and their purchase prices (historical cost) are used to determine their value, which may be significantly understated when compared to the assets’ current market values. Even though it’s difficult to generalize, this historical/current cost differential could be added to a company’s assets in some cases, thereby increasing the company’s equity position and decreasing the company’s debt/equity ratio.
According to accounting principles, firms that use the last-in, first-out (LIFO) inventory cost valuation are more closely matching costs and prices in a rising-price environment. Without getting into the nitty-gritty of accounting, LIFO understates inventory value while overstating cost of sales, resulting in lower reported earnings.
Financial analysts prefer the understated or conservative impact on a company’s financial position and earnings that is generated by the application of LIFO valuations as opposed to other methods such as first-in, first-out (FIFO) and average cost valuations. LIFO valuations are a type of asset valuation method that is used to value assets.
Sentiment in the Stock Market
Approximately once a month, the Bureau of Labor Statistics of the United States Department of Commerce publishes two key inflation indicators: the Consumer Price Index (CPI) and the Producer Price Index (PPI) (PPI).
Consumer and wholesale inflation, as measured by these indices, are the most important measures of inflation in the retail and wholesale sectors, respectively. They are closely followed by financial analysts and receive a great deal of coverage in the media.
The release of the CPI and PPI data can have a directional effect on the markets. Investors appear to be unconcerned about an upward movement (low or moderating inflation reported), but they become extremely concerned when the market falls (high or accelerating inflation reported).
Important to remember about this data is that the trend of both indicators over a long period of time is more relevant to investors than any single release. Investors are advised to take their time in digesting this information and to refrain from overreacting to market fluctuations.
Rates of Interest
When it comes to interest rates, one of the most talked-about topics in the financial press is what the Federal Reserve does with them. The Federal Open Market Committee (FOMC) meets on a regular basis and their meetings are a major news event in the investment community. The Federal Open Market Committee (FOMC) employs the federal funds target rate as one of its primary tools for controlling inflation and the pace of economic growth.
Whenever inflationary pressures are building and economic growth is speeding up, the Federal Reserve will raise the fed-funds target rate, increasing the cost of borrowing and slowing the economy. If the opposite occurs, the Federal Reserve will lower its target interest rate.
Despite the fact that economists believe all of this makes sense, the stock market is much happier in a low interest rate environment than it is in one with a high interest rate environment, which translates into an inflationary outlook of low to moderate. A so-called “Goldilocks” inflation rate—one that is neither too high nor too low—provides the best of both worlds for stock investors.
Purchasing Power of Future
Stocks, rather than fixed-income investments, are generally considered to be a better inflation hedge than fixed-income investments, owing to the ability of companies to raise their prices for goods and services. Inflation, at whatever level it occurs, eats away at bond investors’ principal and reduces their future purchasing power in the long run.
Inflation has been relatively low in recent years; however, it is unlikely that investors will take this as a given in the future. To protect themselves against the eroding effects of inflation, even the most conservative investors would be wise to maintain a reasonable level of equities in their portfolios at all times.
Inflation is a fact of life in the modern economy; it will always be with us. Despite the fact that it is neither intrinsically good nor bad, it has an impact on the investing environment.
The effects of inflation on investors’ portfolios must be understood, and their portfolios must be structured accordingly. Unanimously, investors must maintain a mix of equity and fixed-income investments that generate adequate real returns in order to combat inflationary pressures, depending on their individual circumstances.