The Banking Executive Magazine - July 2022 Issue

Back to Basics (meats and grains), chemical prod- ucts, and metals. If the price in- creases that cause the PPI to spike get passed onto consumers, it will be re- flected in the Consumer Price Index. Below is a description of the various price indexes: The Consumer Price Index (CPI) The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food, and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as avail- able for purchase by the individual citizens. The Wholesale Price Index (WPI) The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. While WPI items vary from one country to other, they mostly in- clude items at the producer or wholesale level. For example, it in- cludes cotton prices for raw cotton, cotton yarn, cotton goods, and cot- ton clothing. The Producer Price Index The producer price index is a family of indexes that measures the average change in selling prices received by domestic producers of intermediate goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the CPI which measures price changes from the perspective of the buyer. In all such variants, it is possible that the rise in the price of one compo- nent (say oil) cancels out the price decline in another (say wheat) to a certain extent. Overall, each index represents the average weighted price change for the given con- stituents which may apply at the overall economy, sector, or com- modity level. THE FORMULA FOR MEASURING INFLATION The price indexes can be used to cal- culate the value of inflation between two particular months or years. While a lot of ready-made inflation calculators are already available on various financial portals and web- sites, it is always better to be aware of the underlying methodology to en- sure accuracy with a clear under- standing of the calculations. Mathematically, percent inflation rate is measured as: Percent Inflation Rate = (Final CPI Index Value/Initial CPI Value) x 100 IMPACT OF INFLATION While consumers experience little benefit from inflation, investors can enjoy a boost if they hold assets in markets affected by inflation. Some companies reap the rewards of inflation if they can charge more for their products as a result of a surge in demand for their goods. If the econ- omy is performing well and housing demand is high, home-building com- panies can charge higher prices for selling homes. In other words, inflation can provide businesses with pricing power and increase their profit margins. If profit margins are rising, it means the prices that companies charge for their products are increasing at a faster rate than increases in produc- tion costs. Also, business owners can deliber- ately withhold supplies from the market, allowing prices to rise to a favourable level. However, compa- nies can also be hurt by inflation if it is the result of a surge in production costs. Inflation often leads to speculation by businesses in risky projects and by individuals who invest in company stocks, as they expect better returns than inflation. An optimum level of inflation is often promoted to encour- age spending to a certain extent in- stead of saving. If the purchasing power of money falls over time, then there may be a greater incentive to spend now instead of saving and spending later. It may increase spending, which may boost eco- nomic activities in a country. A bal- anced approach is thought to keep the inflation value in an optimum and desirable range. Buyers of such assets may not be happy with inflation, as they will be required to shell out more money. People who hold assets denominated in their home currency, such as cash or bonds, may not like inflation, as it erodes the real value of their hold- ings. As such, investors looking to protect their portfolios from inflation should consider inflation-hedged asset classes, such as gold, com- modities, and real estate investment trusts (REITs). Inflation-indexed bonds are another popular option for in- vestors to profit from inflation. High and variable rates of inflation can impose major costs on an econ- omy. Businesses, workers, and con- sumers must all account for the effects of generally rising prices in their buying, selling, and planning decisions. This introduces an addi- tional source of uncertainty into the economy, because they may guess wrong about the rate of future infla- tion. Time and resources expended on researching, estimating, and ad- justing economic behaviour are ex- pected to rise to the general level of prices, rather than real economic fundamentals, which inevitably rep- resents a cost to the economy as a whole. Even a low, stable, and easily pre- dictable rate of inflation, which some consider otherwise optimal, may lead to serious problems in the econ- omy, because of how, where, and when the new money enters the economy. Whenever new money and credit enters the economy it is the BANKING EXECUTIVE 42 ISSUE 163 JULY 2022