Inflation reflects the change in the price of a basket of goods and services over a period of time. If this basket was worth 100 units of currency at the previous measurement and is worth 102 units today, the inflation rate would be 2%. This indicator practically shows by how much the purchasing power of the local currency has fallen.

Due to its key importance at the micro and macro levels, inflation is often a determining factor in a country’s monetary policy. Accordingly, changes in inflation directly and indirectly affect the value of various financial assets.

The reasons for the rise in prices are different. In general, three scenarios can be considered.

The first is the result of an imbalance between supply and demand. When demand for certain goods exceeds supply, the prices of the relevant goods will rise until a new equilibrium is reached between buyers and sellers.

In the second option, inflation is generated by the appreciation of output. When the cost of producing a good or service increases, these costs will be transferred partially or in total to the consumer.

In the third scenario, inflation comes more as a result of people’s expectations that prices will continue to follow the existing appreciation trend. In order to protect their purchasing power, they will demand higher wages and their employers will offer their output at higher prices to provide for them. This wage-price spiral may continue until another factor breaks the cycle.

The above three options do not exhaust the causes of inflation. For example, central bank actions (increasing the money supply) can themselves lead to inflation.

Inflation Indicators

There are various indices to measure inflation. Most commonly, analysts look at the Consumer Price Index (CPI) and the Producer Price Index (PPI).

The CPI reflects the change in the price a consumer must pay to acquire a particular basket of retail goods and services. The basket includes traditional household goods such as food, medical services, transportation, education, clothing, vacations, etc. In practice, this index measures by how much the cost of living has risen over the reporting period.

The Core CPI, which excludes the volatile components of food and fuel, is published alongside the CPI. For many, the Core CPI provides clearer and more stable information.

PPI focuses on the rise in the price of goods and services at the manufacturer. Most often, these are the prices at which he will sell wholesale.

Central banks and inflation

Inflation is a determining factor for the monetary policy of central banks. Many of them have a specifically defined inflation target within their mandate of governance. For advanced economies, it is usually around 2%.

When economic activity is subdued and inflation is low, the central bank will pursue an expansionary policy. In the opposite scenario – an overheating economy accompanied by high inflation, the bank will pursue a restrictive policy to slow these processes down.

How does this happen in practice?

When inflation exceeds levels that are healthy for the economy, the central bank will bring its tools to bear – interest rate hikes, open market operations, etc. Higher interest rates will be transferred to economic participants through the bank sector and their core products – lending and depositing. More expensive loans will cool the investment intentions of households and businesses. At the same time, depositing will become a more attractive alternative. More and more money will be parked in banks instead of circulating in the economy. As a result, demand for certain goods and services will decline and inflation will fall.

The other main tool of central banks – open market operations, will aim for an identical effect. The placement of government bonds in the banking system will suck liquidity out of it, resulting in less money in circulation.

Let us also consider the opposite option, where inflation is too low and central banks’ efforts are focused on raising it.

By lowering interest rates, deposits will become an increasingly unattractive product. Households and businesses will look for investment alternatives with higher rates of return. At the same time, lending is becoming more affordable.

In this environment, the money supply in the real economy is expected to increase, which in turn will boost growth and inflation. This process may be further facilitated by open market purchases of government securities. This will inject additional liquidity into commercial banks, which will transfer it through their credit products to economic entities. We saw similar actions during the global financial crisis of 2008 and during the Covid-19 crisis.

Inflation and Monetary Policy

Despite the close dependence between inflation and monetary policy, it is difficult to build one between inflation and exchange rates. When inflation is within the limits desired by the central bank, it is unlikely to have a significant impact on financial markets. Its influence is more significant when it leaves the economy’s optimal levels, thereby challenging the central bank to act.

If it exceeds the upper limit (about 2% for developed countries), interest rates will be raised. Higher interest rates are likely to attract capital to fixed income instruments. At the same time, however, investment activity, economic growth and consumption will slow. In other words, opposing factors will influence the value of the local currency, which could result in its appreciation or depreciation.

The opposite scenario would also not lead to firm conclusions on exchange rates. Inflation below the central bank’s target will provoke stimulative monetary policy, which in turn will support consumption, investment and growth. In this favorable environment, there will be demand for the local currency. But low interest rates will lead to an outflow of investment from the local debt market. The ultimate effect on exchange rates will be indeterminate.

Does this mean that inflation is not a forward-looking indicator for forex markets

The short answer is “no”. Inflation is a key macroeconomic indicator and as such is an important component of fundamental analysis. In many cases, price increase must be considered in the specific macroeconomic context. For example, high and rising inflation can be generated by increased business activity and growth in household incomes. Against the background of such positive factors, the local currency can be expected to appreciate.

The US economy was developing in a similar atmosphere in the years before the Global Financial Crisis. Let us look at the performance of the US dollar against the Japanese yen during this period.

This currency pair was perceived by many as a “carry trade” due to the large and constantly increasing interest rate differential between the two countries. The carry trade strategy performs well when the global economy is growing steadily and the overall trend is risk-on (risky assets appreciate). It generates profits from both the exchange rate change and the overnight interest (rollover rate).

In this case, inflation in the United States exceeds the central bank’s target, leading to rising interest rates. USD/JPY reacts as expected – the currency with the rising interest rate appreciates (Japan has had interest rates close to 0% for decades and the yen is often used as the price currency in carry trade pairs).

Chart 1: USDJPY Before and After GFC. Chart: Investing.com

Chart 1: USDJPY 2005-2008. Chart: Investing.com

On the chart, we see the prices of USD/JPY for the period 2005-2008. From 2005 to 2006, the Fed raised the target federal funds rate from 2.50% to 5.25%. The currency pair appreciated in this period. However, the carry trade strategy has its risks. When danger looms on the horizon, drastic corrections are common. The decline traces its origins to the bankruptcy of Lehman Brothers in 2007. The Fed also began a rate cut cycle that year, further accelerating the decline.

In the above example, inflation was the catalyst for the rise in interest rates and the corresponding rise in USD/JPY. However, others are driving the decline. This comes to show that inflation must be viewed in the context of the overall economic picture.

Is inflation good or bad for the economy

According to a number of analysts, the presence of moderate inflation (around 1-2%) brings positive effects. It encourages consumers not to postpone their purchases to a future period, as they will then pay more for an identical product. Also, the presence of inflation means that corporations will increase their profits, at least in nominal terms, which should be reflected in higher wages for employees. Otherwise, wages may have to be cut, bringing other distortions in consumption in their wake.

Of course, there is no shortage of critics who believe that inflation reduces the purchasing power of the majority of the population, reducing their opportunities for savings and investment.

Perhaps, the truth lies somewhere in between. When inflation is moderate, stable and predictable, it is unlikely to harm household welfare. But when it is volatile and high, it is likely to have a negative impact.

Other terms related to price changes

When traced over a larger interval of time, it can be seen that inflation is present in most goods and services. The price of housing for the previous generation was almost certainly lower than the price of a similar property today. A similar pattern can be observed for a number of goods. However, this is not a general rule. Some goods and services have become cheaper over the years as a result of production cycle optimization, invention of substitutes and other factors.

Negative inflation (a fall in prices) is called deflation. Logically, it most often occurs in a slowing economy or recession. The purchasing power of money increases in these periods.

Hyperinflation reflects rising prices at an extreme rate, sometimes exceeding 1,000 percent per year.

Disinflation represents a decline in inflation rates, but still a positive one (e.g., a decline from 15% to 5%).

Stagflation is characterized by high inflation and high unemployment with low economic growth.

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