What You Should Know About Inflation

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase as reported in the Consumer Price Index (CPI), generally prepared on a monthly basis by the Bureau of Labor Statistics (BLS). As inflation rises, purchasing power decreases. But that's not all. Fixed-asset values are affected, companies adjust their pricing of goods and services, financial markets react and there is an impact on the composition of investment portfolios.

To some degree or another, inflation is a fact of life. Consumers, businesses, and investors are impacted by upward trends in prices—regardless of how deep or when they appear. In this article, we look at various elements in the investing process affected by inflation and show you what you need to be aware of when you make those important investment decisions.

Financial Reporting and Changing Prices

The Financial Accounting Standards Board (FASB) experimented with inflation accounting between 1979 and 1986. This required companies to include the supplemental constant dollar and current cost accounting information (unaudited) in their annual reports.

The guidelines for this approach were laid out in Statement of Financial Accounting Standards No. 33, which contended that "inflation causes historical cost financial statements to show illusionary profits and mask erosion of capital."

With little fanfare or protest, SFAS No. 33 was quietly rescinded in 1986. Nevertheless, serious investors should have a reasonable understanding of how changing prices can affect financial statements, market environments, and investment returns.

Corporate Financial Statements

In a balance sheet, fixed assets are valued at their purchase prices or their historical costs. These costs may be significantly understated compared to their present-day market values. It's difficult to generalize, but for some firms, this historical/current cost differential could be added to their assets. As such, this would boost their equity positions and improve their debt-to-equity ratios.

When it comes to accounting policies, firms that use the last-in, first-out (LIFO) inventory cost valuation closely match costs and prices in an inflationary environment. Without going into all the accounting intricacies, the LIFO valuation understates inventory value and overstates the cost of sales, thus lowering reported earnings.

Financial analysts tend to like the understated or conservative impact on a company's financial position, not to mention any earnings that are generated by the application of LIFO valuations as opposed to other methods such as first-in, first-out (FIFO) and average cost.

Market Sentiment

The BLS releases reports on two key inflation indicators every month: the CPI and the Producer Price Index (PPI). These indexes are the two most important measurements of retail and wholesale inflation, respectively. They are closely watched by financial analysts and receive a lot of media attention.

The releases for both the CPI and PPI can move markets in either direction. Investors do not seem to mind an upward movement (low or moderating inflation reported) but get very worried when the market drops (high or accelerating inflation reported).

The important thing to remember is that it is the trend of both indicators over an extended period of time that is more relevant to investors than any single release. Investors are advised to digest this information slowly and not to overreact to the movements of the market.

Interest Rates

One of the most reported issues in the financial press is what the Federal Reserve does with interest rates. The periodic meetings of the Federal Open Market Committee (FOMC) are a major news event in the investment community.

The FOMC uses the federal funds target rate as one of its principal tools for managing inflation and the pace of economic growth:

• If inflationary pressures build and economic growth accelerates, the Fed will raise the fed funds target rate to increase the cost of borrowing and slow down the economy.
• If inflation drops and the economy begins to slow down, the Fed will push its target rate lower.

All of this makes sense to economists, but the stock market is much happier with a low interest rate environment than a high one. That's because it translates to a low to moderate inflationary outlook. A so-called Goldilocks inflation rate, which is neither too high nor too low, provides the best of times for stock investors.

Future Purchasing Power

There's a general assumption that stocks are a better hedge against inflation than fixed-income investments. Why? Most people it's because companies can raise their prices for goods and services. For bond investors, inflation eats away at their principal and reduces future purchasing power whatever level inflation hits.

Inflation has been fairly tame in the modern era. But it's doubtful that investors can take this circumstance for granted. It would be prudent for even the most conservative investors to maintain a reasonable level of equities in their portfolios to protect themselves against the erosive effects of inflation.

The Bottom Line

Inflation will always be with us—that's just an economic fact of life. While it may not intrinsically be good or bad, it certainly does impact the investing environment. Investors need to understand the impacts of inflation and structure their portfolios accordingly. One thing is clear though. Depending on personal circumstances, investors need to maintain a blend of equity and fixed-income investments with adequate real returns to address inflationary issues.