When you’re studying the economy and trying to make smart investments, you’ll hear a lot about economic indicators. These financial figures are measured on a regular basis so that analysts can track whether we’re doing better or worse from week to week, month to month, and year to year. One of the most important signs they’re looking for is inflation.
Inflation is how much your money is worth – not in terms of other currencies or a gold standard, but how much it will buy of the things you need and want. For example, if you have $10 to spend, can you get a diamond ring or a box of crackerjacks? Will that money last you through the month or will it barely get you through a couple of days? The answer changes over time and how much it changes is called inflation. If people can buy more, it’s good for the companies that sell stuff and therefore good for the stock market and the economy overall. That’s why some of the most popular economic indicators are the ones that measure inflation.
So How Do You Measure It? Inflation is measured by comparing prices of things now to the prices of the same things in the past. The results of inflation will show up on the price tags of things that you use all the time, ranging from toys to electronics to clothes to whatever you had for lunch. We can break it down further with a simple menu.
Let’s say you make lunch in your own kitchen. You decided to have a roast beef sandwich with fries and a cup of coffee (with milk and sugar). You’re trying to eat healthy so you add a nice cabbage salad on the side and an orange for dessert. Of course, everyone likes a different size sandwich, so we’ll buy a pound of most of our ingredients and you can put the rest back in the refrigerator for later in the week:
Grocery shopping for this meal will cost you $23.69. But that only tells us something about inflation if we have another price to compare it to. Thanks to the Federal Reserve Bank of St. Louis’ FRASER digital archive, anyone can check out how much this meal would have cost in the past. Let’s go back 100 years:
Of course, this is an estimate. The actual price would depend on lots of factors, including your location and time of year. But on average, the same shopping list would have cost you $1.92. That’s more than 1000% inflation! Now don’t panic. Remember that that’s over the course of 100 years. Earning power has gone up along with prices and, most importantly, this is a very simplified example.
Then How Does it Really Work?
There are a few economic indicators that are used to measure inflation but the most popular one is the CPI, or Consumer Price Index. The CPI is basically a much more complicated version of our roast beef sandwich. It includes the prices for everything from clothes and food to appliances and fuel. It’s calculated monthly, so last month it was 0.2% and 2.9% for the year.
What Does It Mean for Me?Most economists agree that a little bit of inflation is a good thing. It’s when it’s moving too fast that we run into trouble. If income doesn’t keep up, then people can buy less stuff. At the same time, they’re nervous about the future value of their money and are less likely to save and invest. Inflation can even affect currency exchange rates, which in turn influence imports and exports. All of this effects the economy overall and the stock market in particular.
So What Do I Do?
Fortunately, as an investor, there’s a simple way to protect yourself from the effects of inflation: don’t do anything. History has shown that the stock market will eventually recover. If you can afford to keep your money invested, your best bet is to simply hold on tight and enjoy the ride.