What is the GDP deflator? Why is it important?

This article will analyze the GDP Deflator, a handy indicator for understanding inflation in the United States. Many investors are looking for ways to defend themselves against the rising prices. Understanding how to calculate inflation is fundamental.

The GDP Deflator is a measure of price changes in goods and services produced during a year. This indicator reflects reality better than the more popular Consumer Price Index CPI indicator.

The real GDP of the United States represents the monetary value of all products and services in an entire year. This indicator does not take into account products imported from other countries. 

The real GDP, Real Gross Domestic Product, is a GDP adjusted for present inflation. GDP is the same indicator, but without this price inflation-based adjustment.

We use nominal GDP and real GDP to calculate the GDP Deflator. 

GDP Deflator chart
Chart from fred.stlouisfed.org: Link

For example, we could have a nominal GDP of 25 trillion dollars and a real GDP of 23 trillion dollars. The 5 trillion difference represents inflation. 

We will obtain the GDP Deflator by dividing the nominal GDP by the real GDP and multiplying it by 100. Following our example, the result will be 108 (25 trillion / 23 trillion x 100 = 108). Based on our model, the gross domestic product implicit price deflator indicates a price increase of 8% from the base year.

The critical difference between the GDP Deflator and the CPI

The GDP Deflator is an index that reflects reality better than the CPI. One of the significant limitations of the CPI is having a specific basket of objects as a reference. All the goods and services produced are calculated; therefore, a hypothetical new invention is not included in the CPI.

However, to measure inflation, the CPI is better because it also includes the prices of imported products.

Consumers do not only buy goods and services produced in the United States. About 20% of their spending consists of imported goods. The GDP deflator does not take this large percentage into account, and this is a significant limitation.

consumer price index chart
Chart from tradingeconomics.com: Link

In any case, inflation is generally a worldwide trend. We will hardly see out-of-control inflation in Europe and a low price level in the United States.

In this reasoning, however, we must necessarily include the impact of monetary exchange rates, representing a sort of disguised inflation. A rise in the Euro or the Yuan against the dollar would raise prices for American consumers, effectively creating inflation. 

This type of inflation would be correctly calculated by the CPI but not by the GDP Deflator.  However, we must consider the increase in semi-finished products and commodities, the latter found in the GDP Deflator.

GDP Deflator and imports from China

In this paragraph, I mainly consider China because, in my opinion, it is the discounter of the modern world. The explosion of consumerism had its splendor primarily thanks to the mass production of products from China. The amount of products purchased by consumers is infinitely higher than 30 years ago. Products imported from China have made the impossible possible.

Products imported from China and purchased by consumers do not have a direct impact on GDP. Therefore, if Chinese products increased the price, they would not affect the GDP Deflator or the CPI.

We must consider that China’s imported products are also semi-finished products that become final products in the United States. An increase in China’s prices would indirectly reflect the GDP Deflator, albeit lesser than the CPI.

If China were to start an inflationary phase, it would be a big problem for the whole world. China is more able than any other country to export inflation to the world. Unfortunately, over the years, almost all industrialized countries have tied themselves to the Chinese market, a not precisely reliable trading partner.

GDP Deflator and Federal Reserve Inflation’s calculation

The Federal Reserve has the main task of keeping inflation under control and precisely below the 2% level. The Fed seems much more careful about keeping the S&P at all-time highs than at inflation levels. 

The US central bank does not directly use the GDP Deflator to calculate the price level. The most important indicator for central banks is the Personal Consumption Expenditures (PCE). The FED uses many other parameters like the GDP Price Index or the investment patterns, including the Implicit Price Deflator. 

The PCE calculates the household’s expenses in a given period of time. PCE is very similar to the CPI, but it adapts faster to changes. Furthermore, the PCE is calculated through the data provided by the companies, while the CPI directly examines prices.

The volatility of the PCE is lower than the CPI and higher than the GDP deflator. The PCE’s accuracy is undoubtedly more significant than the GDP Deflator. Anyway, using more indicators allows you to have a complete view of the market.

When it comes to inflation-related investments, always remember that expectations are sometimes more critical than actual price levels. Many financial instruments react quickly to inflation expectations. Investors that use more reactive indicators such as the CPI or the PCE could anticipate the market movements.

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