sidered quite large for the core rate of inflation and would significantly
affect the financial markets.
Another inflation indicator that both Fed chairmen Alan Greenspan
and Ben Bernanke have supported is the personal consumption expenditure
(PCE)deflator, which is the price index calculated for the consumption
component of the GDP accounts. The PCE deflator differs from the con-
sumer price index in that the PCE deflator uses a more up to date
weighting scheme and includes the cost of the employer-paid as well as
the employee-paid medical insurance.
Employment Costs
Other important releases bearing on inflation relate to labor costs. The
monthly employment report issued by the BLS contains data on the
hourly wage rate. This report sheds light on cost pressures arising in the
labor market. Since labor costs average nearly two-thirds of a firm’s pro-
duction costs, increases in the hourly wage not matched by increases in
productivity increase labor costs and threaten to cause inflation.
Every calendar quarter, the government also releases the employment
cost index(ECI). This index includes benefit costs as well as wages, and it
is considered the most comprehensive report of labor costs. The Federal
Reserve considers this a more important indicator of inflation than the
hourly wage, so the financial markets closely scrutinize these data.
IMPACT ON FINANCIAL MARKETS
The following summarizes the impact of inflation on the financial markets:
A lower-than-expected inflation report lowers interest rates and boosts
bond and stock prices. Inflation worse than expected raises interest rates
and depresses stock and bond prices.That inflation is bad for bonds should come as no surprise. Bonds
are fixed-income investments whose cash flows are not adjusted for in-
flation. Bondholders demand higher interest rates to protect their pur-
chasing power when inflation increases.
Worse-than-expected inflation is also bad for the stock market. As
I noted in Chapter 11, stocks have proven to be poor hedges against in-
flation in the short run. Stock investors know that worsening inflation
increases the effective tax rate on both corporate earnings and capital
gains and induces the central bank to tighten credit, raising real interest
rates.
246 PART 3 How the Economic Environment Impacts Stocks