The news regularly reports that this or that stock market index has reached new heights. What does that really mean?
Economies tend to grow, whether it’s their population or their productivity, so it’s natural that their economic statistics would also increase. Prices generally increase as well, which means that even if an economy doesn’t grow, economic measures will increase. That is, if those measures aren’t cleared of general price inflation (“deflated”). Eventually, any stock index will also appear to increase over time. It will have ups and downs—sometimes big ones—but eventually it will set new records.
Let’s consider the example shown in the graph above, which is the Nikkei index for the Japanese stock market over the past 10 years. It seems to have been increasing and, in fact, setting quite a few new records along the way. But has it?
Our second graph shows 60 years of data for the same index. The dramatic run up in 1990 was clearly the record high for the Nikkei, which it has yet to match. But little by little, it’s getting closer to that level and eventually a new record will be set. On this graph, the Nikkei is 74% of the way there.
Our third graph has taken care of the general price inflation problem by dividing the Nikkei by the consumer price index for Japan. This price index pertains only to consumption and not to general output, but it’s the series that is long enough and close enough for our purposes here.
We see from the graph that the record high in 1990 is actually a longer way off: The Nikkei’s current level is really only 68% of the way there. The difference between 68% and 74% isn’t actually that large, thanks to low inflation in Japan. Had Japanese inflation been higher, we might have seen a much bigger difference. But look at the early decades in this graph and you’ll notice crashes that were hidden by inflation in the last graph. Inflation helped the Nikkei reach new records, but adjusting for inflation reveals when the index was actually decreasing.
How these graphs were created: Search FRED for “NIKKEI” and you have the first graph with the default 10 years of data. For the second graph, expand the sample period of the first graph to include all available years, either by clicking on “MAX” above the graph or by playing with the slider below the graph. For the third graph, use the “Edit Graph” panel to search for and add “Japan CPI” and apply formula a/b*100.
Suggested by Christian Zimmermann.