Inflation

Inflation is the reason why elder generations like to complain about today's prices - even if nothing really has changed. But when and how should you consider it in your financial model?

Inflation is the term describing the general rise of the price level within an economy. Under the influence of inflation, the price for the same good in the future will be higher than today.

In an inflation context, we speak of "nominal" and "real" prices. If an economy's overall inflation rate is 2%, and a certain good costs 100 units of money today, and 102 units of money in a year's time, its nominal price increased by 2%, but its real price stayed the same - that is, taking the future nominal price and adjusting it for the inflation rate, which in this example happens to be the same as the price increase.

Should inflation be considered in financial models?

This question cannot be answered easily. It usually depends on the context. If you can generally assume that all factors in the model are affected in the same way by inflation, you can consider to neglect it. You would then build your model based on real figures (as opposed to nominal figures) but should make sure to communicate that to everyone else working with the model or its outputs to make sure that you are not comparing apples and oranges when discussing numbers.

There are cases, however, when inflation will definitely affect some numbers in your model, but will not affect others in the same way. One example are government subsidies. One good example are feed-in tariffs for renewable energy projects: You might build a model for a renewable energy project in which the revenues are determined by a law that effectively sets a price per kWh that you can charge. Commonly, those feed-in tariffs are not meant to be inflation-adjusted. For long-running projects that implies that the revenues will be fixed at their nominal value, whereas costs will rise due to inflation. (Effectively, the real value of the revenues will decline, because the nominal value stays fixed.) In such a scenario, you cannot ignore inflation and must include it in the model to ensure accuracy.

Sources for inflation rates

European Monetary Union

In the Euro area, the European Central Bank (ECB) follows the official directive of keeping the economy's inflation at a low level around 2%. For long-term forecast numbers, use this target rate.

USA

The Federal Reserve Bank (or "Fed") does not have a clear inflation target such as the ECB. Rather, its goal is to improve the employment rate, ensure price stability and ensure moderate long-term interest rates. For the future inflation rates in financial models, historical averages seem reasonable. But in case you want to make your forecasts extremely sophisticated, you can go the extra mile and deduct the market's expectation of future inflation by comparing the return on Treasury Inflation-Protected Securities (TIPS) to the return on "normal" Treasury bonds. (Barclays offers a list of countries issuing such bonds, in case you need to kill some time for your model's accuracy.)

OECD member countries

The OECD offers comprehensive historical data for the OECD member states in OECD.Stat.

Other markets

For all other markets, it makes sense to refer to the local central bank. This list provides you with links to central banks around the world.

Terminal growth

Economic theory predicts that, as long as economic profits are made in a market with little to no entry barriers, competition will bring down those profits until an equilibrium is met. That implies that at some point, one company's growth will not exceed the growth of its market.

At the same time, the real output of an economy is supposed to constantly rise over time due to ever-improving technological efficiency. Of course, you could also argue that a growing world population will be a factor, too. In essence, the assumption is that there will be growth until infinity. In a financial model, this growth will be reflected in the terminal planning year and is therefore called "terminal growth rate".

Sometimes, companies will plan a terminal growth rate that is suspiciously similar to the inflation rate - because "we will grow in line with inflation". But, as explained above, the principles are different: Terminal growth is something that could theoretically happen at an inflation of 0%. When building your model, you need to make sure that those principles are not thrown together into a strange mix.

One Reply to “Inflation”

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.