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Investors are likely to hear the terms inflation and gross domestic product (GDP) just about every day. They are often made to feel that these metrics must be studied as a surgeon would study a patient's chart before operating.

Most investors have some concept of what inflation and GDP mean and how they interact, but when the best economic minds in the world can't agree on fundamental distinctions between how much the U.S. economy should grow, or how much inflation is too much for the financial markets to handle, it can be hard to know what to do.

Individual investors need to find a level of understanding that assists their decision-making without inundating them with too much unnecessary data. Find out what inflation and GDP mean for the market, the economy, and your portfolio.

Key Takeaways

• Individual investors need to find a level of understanding of gross domestic product (GDP) and inflation that assists their decision-making without inundating them with too much unnecessary data.
• If the overall economic output is declining, or merely holding steady, most companies will not be able to increase their profits (which is the primary driver of stock performance); however, too much GDP growth is also dangerous.
• Over time, the growth in GDP causes inflation—inflation, if left unchecked, runs the risk of morphing into hyperinflation.
• Most economists today agree that a small amount of inflation, about 1% to 2% a year, is more beneficial than detrimental to the economy.

Basic Terminology

Inflation

Inflation can mean either an increase in the money supply or an increase in price levels. When we hear about inflation, we are hearing about a rise in prices compared to some benchmark. If the money supply has been increased, this will usually manifest itself in higher price levels—it is simply a matter of time. For the sake of this discussion, we will consider inflation as measured by the core Consumer Price Index (CPI), which is the standard measurement of inflation used in the U.S. financial markets. Of more importance is the measurement of core inflation. Core CPI excludes food and energy from its formulas because these goods show more price volatility than the remainder of the CPI.

Gross Domestic Product (GDP)

Gross domestic product (GDP) in the United States represents the total aggregate output of the U.S. economy. It is important to keep in mind that the GDP figures, as reported to investors, are already adjusted for inflation. In other words, if the gross GDP was calculated to be 6% higher than the previous year, but inflation measured 2% over the same period, GDP growth would be reported as 4%—or the net growth over the period.

The Delicate Dance of Inflation and GDP

The Relationship Between Inflation and GDP

The relationship between inflation and economic output (GDP) plays out like a very delicate dance. For stock market investors, annual growth in the GDP is vital. If the overall economic output is declining, or merely holding steady, most companies will not be able to increase their profits (which is the primary driver of stock performance). However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable. Most economists today agree that 2.5 to 3.5% GDP growth per year is the most that our economy can safely maintain without causing negative side effects. But where do these numbers come from? To answer that question, we need to bring a new variable, unemployment rate, into play.

Studies have shown that over the past 20 years, annual GDP growth over 2.5% has caused a 0.5% drop in unemployment for every percentage point over 2.5%. It sounds like the perfect way to kill two birds with one stone—increase overall growth while lowering the unemployment rate, right? Unfortunately, however, this positive relationship starts to break down when employment gets very low, or near full employment. Extremely low unemployment rates have proved to be more costly than valuable because an economy operating at near full employment will cause two important things to happen:

1. Aggregate demand for goods and services will increase faster than supply, causing prices to rise.
2. Companies will have to raise wages as a result of the tight labor market. This increase usually is passed on to consumers in the form of higher prices as the company looks to maximize profits.

Over time, the growth in GDP causes inflation. Inflation, if left unchecked, runs the risk of morphing into hyperinflation. Once this process is in place, it can quickly become a self-reinforcing feedback loop. This is because, in a world where inflation is increasing, people will spend more money because they know that it will be less valuable in the future. This causes further increases in GDP in the short term, bringing about further price increases. Also, the effects of inflation are not linear. In other words, 10% inflation is much more than twice as harmful as 5% inflation. These are lessons that most advanced economies have learned through experience; in the U.S., you only need to go back about 30 years to find a prolonged period of high inflation, which was only remedied by going through a painful period of high unemployment and lost production as potential capacity sat idle.

How Much Inflation Is Too Much?

So how much inflation is "too much"? Asking this question uncovers another big debate, one argued not only in the U.S but around the world by central bankers and economists alike. There are those who insist that advanced economies should aim to have 0% inflation, or in other words, stable prices. The general consensus, however, is that a little inflation is actually a good thing.

The biggest reason behind this argument in favor of inflation is the case of wages. In a healthy economy, market forces will, at times, require that companies reduce real wages, or wages after inflation. In a theoretical world, a 2% wage increase during a year with 4% inflation has the same net effect to the worker as a 2% wage reduction in periods of zero inflation. But out in the real world, nominal (actual dollar) wage cuts rarely occur because workers tend to refuse to accept wage cuts at any time. This is the primary reason that most economists today (including those in charge of U.S. monetary policy) agree that a small amount of inflation, about 1% to 2% a year, is more beneficial than detrimental to the economy.

The Federal Reserve and Monetary Policy

The U.S. essentially has two weapons in its arsenal to help guide the economy toward a path of stable growth without excessive inflation: monetary policy and fiscal policy. Fiscal policy comes from the government in the form of taxation and federal budgeting policies. While fiscal policy can be very effective in specific cases to spur growth in the economy, most market watchers look to monetary policy to do most of the heavy lifting in keeping the economy in a stable growth pattern. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) is charged with implementing monetary policy, which is defined as any action to decrease or increase the amount of money that is circulating in the economy. Whittled down, that means the Federal Reserve (FED) can make money easier or harder to come by, thereby encouraging spending to spur the economy and constricting access to capital when growth rates are reaching what is deemed unsustainable levels.

Before he retired, Alan Greenspan was often referred to as being the most powerful person on the planet. Where did this impression come from? Most likely it was because Mr. Greenspan's role as Chair of the Federal Reserve (In 2020, this role is currently occupied by Jerome Powell) provided him with "special" powers—chiefly the ability to set the Federal Funds Rate. The "Fed Funds" rate is the rock-bottom rate at which money can change hands between financial institutions in the United States. While it takes time to work the effects of a change in the Fed Funds rate (or discount rate) throughout the economy, it has proved very effective in making adjustments to the overall money supply when needed.

Asking the small group of men and women of the FOMC, who sit around a table a few times a year, to alter the course of the world's largest economy is a tall order. It's like trying to steer a ship the size of Texas across the Pacific—it can be done, but the rudder on this ship must be small so as to cause the least disruption to the water around it. Only by applying small opposing pressures or releasing a little pressure when needed can the Fed calmly guide the economy along the safest and least costly path to stable growth. The three areas of the economy that the Fed watches most diligently are GDP, unemployment, and inflation. Most of the data they have to work with is old data, so an understanding of trends is very important. At its best, the Fed is hoping to always be ahead of the curve, anticipating what is around the corner tomorrow so it can be maneuvered around today.

Calculating GDP and Inflation

There is as much debate over how to calculate GDP and inflation as there is about what to do with them when they're published. Analysts and economists alike will often start picking apart the GDP figure or discounting the inflation figure by some amount, especially when it suits their position in the markets at that time. Once we take into account hedonic adjustments for "quality improvements," re-weighting, and seasonality adjustments, there isn't much left that hasn't been factored, smoothed, or weighted in one way or another. Still, there is a methodology being used, and as long as no fundamental changes to it are made, we can look at rates of change in the CPI (as measured by inflation) and know that we are comparing from a consistent base.

Implications for Investors

Keeping a close eye on inflation is most important for fixed-income investors because future income streams must be discounted by inflation to determine how much value today's money will have in the future. For stock investors, inflation, whether real or anticipated, is what motivates us to take on the increased risk of investing in the stock market, in the hope of generating the highest real rates of return. Real returns (all of our stock market discussions should be pared down to this ultimate metric) are the returns on investment that are left after commissions, taxes, inflation, and all other frictional costs are taken into account. As long as inflation is moderate, the stock market provides the best chances for this compared to fixed income and cash.

There are times when it is most helpful to simply take the inflation and GDP numbers at face value and move on, especially since there are many other things that demand our attention as investors. However, it is valuable to re-expose ourselves to the underlying theories behind the numbers from time to time so that we can put our potential for investment returns into the proper perspective.

What happens to GDP when inflation rises?

Does inflation cause real GDP to increase?

Does inflation mean the economy is growing too fast?

What is the relationship between inflation and growth?