Download eurozone inflation falls to 1.1%—so what?

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EUROZONE INFLATION FALLS
TO 1.1%—SO WHAT?
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Most people are acutely aware of the impact inflation has on their spending
power, but what causes it and how could it affect your personal finances—
for better or worse?
Unpacking the macroeconomic forces behind the investment industry and
helping make the latest global economic news relevant to all is one of the
core purposes of the Investment Foundations from CFA Institute.
Applying terminology from the purposes of the CFA Institute Investment
Foundations™ Program course of study, let’s take a look at a recent article
on inflation and its effect on the economy and households.
A Brief Introduction
But What Is Inflation And What Causes It?
In September 2013, the BBC reported that “consumer price
inflation fell to an annual rate of 1.1% in September from
1.3% in August according to Europe’s statistics agency
Eurostat. A fall in energy prices helped to ease inflation.
Price rises in food, alcohol and tobacco moderated,
also helping.”
Inflation (covered in Module 3 of the Investment
Foundations Program), defined as a general rise in prices
for goods and services, is essentially an issue of supply
versus demand. Among economists, there are two schools
of thought that attempt to explain the forces that lead to
inflation: the monetarist view and the resource slack view.
Most householders are aware of the negative impact of
inflation on their spending power, but what actually causes
inflation and how might it affect your finances, for better or
worse, through the investments you hold?
According to the monetarist view, if the supply of money
into the economy is large, then more funds are chasing
the same number of goods, pushing prices higher, and
creating inflation. Monetarists believe that a central
bank (for example, the European Central Bank or the US
Federal Reserve Board) can directly influence inflation by
increasing or decreasing the money supply in the economy
to increase or reduce inflation. But the monetarist view that
there is a relationship between inflation and the amount
of money in circulation cannot explain all inflationary
episodes in history. It does not explain, for instance,
inflation stemming from external sources, such as a large
and prolonged oil price rise.
Now, let’s take a look at the resource slack view. This
school of economics argues that inflation is driven by the
costs of production. The resource slack view focuses on
the availability and utilisation of resources (also known
as factors of production) and suggests that a shortage of
resources, capital, or labour leads to increased production
costs. Higher costs for producers are eventually passed on
to consumers in the form of higher prices, or inflation.
To summarise the differing viewpoints, the monetarist
view is that the supply of money dictates demand for
products and thus drives prices and inflation, whereas the
resource slack view is that the availability of capital and
labour dictate prices and inflation. In reality, both concepts
are relevant—both the money supply and central bank
activities, as well as supply and demand for production
inputs, should be monitored to anticipate changes in the
rate of inflation. If we relate these concepts to the BBC
website item, then monetarists might argue that the fall in
the European rate of inflation was caused by a reduction
in the money supply, whereas proponents of the resource
slack view might argue that the cause was a fall in
production inputs.
There are variants on that basket of goods that can lead to
the reporting of different inflation measures. For example,
economic policymakers are mainly concerned with core
inflation, which excludes the effects of temporary volatility
in the prices of commodities, such as food and energy.
So, the inflation rate most relevant to households and
producers, the CPI, may differ from the core inflation rate.
Inflation’s Impact
Inflation does not just affect household spending; it affects
many other parts of the economy, including financial
investments. Consider bonds or other investments, which
pay a fixed cash amount from the return. If an investment
provides the same cash flow each year and prices are
increasing, then that amount of cash flow will be worth
less each year in terms of spending power. This decrease
can be a real problem for pensioners, for instance, who
may have bought a retirement investment product that
offers them a fixed return. If prices rise, that fixed return
buys fewer goods over time and their standard of
living suffers.
The impact of inflation on shares is more difficult to
analyze. In some economic environments, shares provide
some protection against inflation. For example, companies
may be able to increase the selling prices of their goods
or services as the costs of their inputs increase, and thus
their profits and share price will not be negatively affected.
But for some companies, raising selling prices may result
in a fall in sales. If they want to stop that fall, they are
forced to hold prices at their current levels, and thus their
profits (and share price) decline.
What About The Measurement
of Inflation?
Our Lesson In Clarity: Inflation
How do we quantify the rate at which prices are rising
or falling? The most common method is to measure the
percentage change in an index from period to period. For
example, a consumer price index (CPI) is constructed
by determining the weight (or relative importance) of
each good and service in a typical household’s spending
(referred to as a basket of goods) in a particular base year
and then measuring the price change of the whole basket
of goods with reference to the base year.
We can see that behind a news item that gives us an
apparently simple piece of information lies an untold story.
One of the aims of the Investment Foundations certificate
program is to equip learners to be better able to make
sense of the economic news they hear and read. So, when
they hear that European consumer price inflation has
fallen, they are able to understand why it has fallen, how
that fall has been measured, and the relevance of the fall
for consumers and their investments.
For more information, please go to cfa.is/InvFound.
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