Inflation Shows Biggest Drop in Six Years

Inflation is the sustained increase in the general price level of goods and services.  As inflation rises, every dollar buys a smaller amount of goods.  For example, if the inflation rate is 2%, then a $1 loaf of bread will cost $1.02 a year from now.

The consumer-price index is a broad gauge of inflation.  It measures what Americans pay for consumer goods and services, such as transportation, food and medical care.  Last Friday the Labor Department said that the consumer-price index rose just 0.8% in December from a year earlier.  It rose at the slowest annual pace in more than 5 years and the trend will continue in the coming months primarily due to plunging global oil prices.

Low inflation has many economic benefits.  When inflation is low, companies are more confident when making long-term investment plans because their purchasing power will hold and this will eventually lead to an increase in employment and higher economic growth.  Low inflation also acts like an income boost for consumers.  By eroding less purchasing power, it increases a household’s disposable income and thus encourages higher household spending.  Additionally, low inflation makes it more appealing to borrow money, since interest rates are generally low during periods of low inflation. This encourages households to buy more durable goods, such as houses and cars.

However, when inflation growth is too low a fear of deflation exists.  Deflation is a decrease in the general price level of goods and services.  Generally deflation negatively impacts a country’s economic condition because deflation often freezes spending.  Who wants to go out and buy an item now if they expect it to be cheaper in six months?

Therefore, maintaining a reasonable inflation rate is an important goal for the U.S. central bank.  After all, consumer spending generates more than two-thirds of U.S. economic output.

As investment professionals, we monitor inflation as one of the variables of importance when doing financial analysis.  Hence, large or sudden changes in inflationary expectations can have a pronounced effect on asset prices. 

All comments and questions are welcome.

Wenny Gorman, CFA®