Inflation
The significance of inflation in the stock market should not be overlooked. For investors, the idea of rising prices has two separate meanings.

First, it means that goods cost more; second, it means that the value of investments potentially changes. Inflation is normally reported in percentage terms, meaning increases or decreases (deflation) from one period to another. This change is reported nationally as the Consumer Price Index (CPI), which is computed and published by the Bureau of Labor Statistics. The CPI is a combined index made up of major groups, which include consumer expenditures for food and beverages, housing, apparel and upkeep, transportation, medical care, entertainment, and other goods and services. The most commonly cited index is properly called the CPI-U, or the Consumer Price Index for All Urban Consumers. This encompasses the spending of approximately 80 percent of the U.S. population. The second of the two indexes is the CPI-W, or Consumer Price Index for Urban Wage Earners and Clerical Earners, which reports on spending for approximately 32 percent of the U.S. population. The CPI is an important economic indicator because it tracks and reports the changes in prices of goods and services purchased in urban households. (For more information about inflation, the CPI, and the Bureau of Labor Statistics, connect to Web site: stats.bls.gov.)
KEY POINT
To investors, inflation means not only that prices rise, but also that the profitability of their investments might change as well.
Inflation often is misunderstood as causing prices to rise when, in truth, it is the outcome of rising prices. The economy is a complex interchange between goods and services and consumer demand. Corporate price increases reflect higher prices of raw materials, labor,» and other costs and expenses for the corporation; it is not the act of rais-| ing prices that causes inflation. In the August 1, 1967, issue of Forbes, Roger Blough stated: "Steel prices cause inflation like wgt sidewalks cause rain."                     
The relationship between inflation and the stock market is direct, because as the rate of inflation grows, it is seen as a negative factor for corporations. Inflation affects business in general and usually indicates higher interest rates as well as prices, meaning ultimately less consumer spending. The consequence is lower sales and profits for the corporation. So watching the rate of inflation is relevant to investment climate as well as to the standard of living in all American households. Investors observing the long-term effects of inflation also realize that the real test of investment success is its ability to outpace inflation over time. You really stay ahead of inflation if you can beat its rate on an after-tax basis.
Inflation is reported in the form of a changing index, based on a starting point of 100. Each period's reported change has a value related to this starting point. A typical report shows the latest data is compared to the level the year before, and a rate of inflation is computed.

The rate of inflation is computed by first figuring out the change between the current CPI and last year's CPI; and then dividing the change by last year's CPI. If the rate is lower, the change is reported as a negative. The formula for reporting the rate of inflation is shown in Figure 11.1.

FIGURE 11.1 Rate of Inflation (rounded to one decimal)