Inflation is a familiar term that profoundly impacts daily life. Since the global surge in 2021-2023, it has become a frequent topic among the public and a key focus in financial markets, including stocks and forex. This article will explain the meaning of inflation, its causes, and how it is measured. It will also analyze the impact of inflation on Forex trading.
Inflation Meaning
Inflation is a phenomenon where the general level of prices for a range of goods and services rises over a period of time, resulting in a decrease in the purchasing power of money. In other words, means that over time, each unit of currency would buys fewer goods and services that it did previously.
Assuming the annual inflation rate in May 2024 is 5%, it can be interpreted as prices rising by 5% over the year or the currency depreciating by 5% in value. Below is an example of inflation:
| Price Level in May 2023 | Price Level in May 2024 | |
| Same Basket of Goods & Services | $100 | $105 |
Inflation is the primary focus of central banks around the globe, including the Federal Reserve and the European Central Bank, which play a crucial role in controlling inflation through monetary policy. Their primary objective is to stabilize prices to ensure economic stability.
So how exactly can inflation be measured, and what indicators do these central banks use to measure inflation? We will be explaining further in the following section.
Measurement of Inflation
Inflation is often measured by the Consumer Price Index (CPI) or the Producer Price Index (PPI), both of which track the prices of a basket of goods and services over time from the consumer and producer perspectives, respectively.
Different countries and regions may use different methods and inflation indices to measure. Using the world’s largest economy—the United States—as an example, there are various types of inflation indices used to measure price changes:
1). Consumer Price Index (CPI)
The Consumer Price Index measures the average change over time in the prices paid by urban consumers for a basket of consumer goods and services. For public and the end consumers, the Consumer Price Index growth rate is the most direct way to measure inflation.
3). Personal Consumption Expenditure (PCE)
The PCE is a unique U.S. inflation meansure, which refines the CPI by excluding highly volatile items like energy and including business data. This makes it a more accurate reflection of consumer price changes.
2). Producer Price Index (PPI)
The PPI measures the price changes on the production side, covering materials that businesses need to purchase during the production. PPI is correlated with CPI in long-term as price changes on the production side may eventually be passed on to the consumer side.
4). GDP Deflator
The GDP Deflator is calculated by dividing nominal GDP by real GDP. Nominal GDP is the GDP measured at current market prices, while real GDP is calculated using the prices from a base year, reflecting constant price levels.
Among all these inflation measure, the Consumer Price Index (CPI) is one of the most closely watched inflation index. Many people, including the media, often equate the CPI with inflation index.
However, in the United States, the Personal Consumption Expenditure (PCE) index is the primary measure used by the Federal Reserve to justify inflation. The PCE index is considered more comprehensive as it accounts for changes in consumer behavior and includes a broader range of expenditures, making it a more accurate reflection of inflation.
Causes & Types of Inflation
In modern economic theory, inflation can be caused by various factors and can be categorized into different types. One of the most common explanations is monetary oversupply, where an excess of money in the economy leads to too much money chasing too few goods and services, driving up prices.
In general, the cause and types can be broadly categorized into three types of inflation. Here’s a closer look at each:
1. Demand-Pull Inflation
Demand-Pull Inflation is when demand for goods and service exceed supply, prices rise and caused inflation. This often occurs in a growing economy where consumers have more disposable income to spend and driving up the demand. Here are some common causes of the demand-pull inflation:
- Increased government spending can boost demand, leading to higher prices.
- When central banks lower interest rates, borrowing becomes cheaper, resulting in increased spending and investment, which can also drive-up prices.
2. Cost-Push Inflation
Cost-Push Inflation occurs when rising production costs, such as increased prices for raw materials, labor, or other inputs, lead producers to pass these costs onto consumers, resulting in higher prices. Cost-push inflation can be challenging to control as it often arises from factors beyond the influence of domestic economic policy. Common causes of cost-push inflation include:
- Events like natural disasters or geopolitical tensions can disrupt supply chains, reduce the availability of goods, and drive up prices. For example, an increase in oil prices due to geopolitical conflict can lead to higher transportation and production costs, resulting in inflation.
- Depreciation of the national currency can make imports more expensive, leading to higher costs for businesses that rely on import, which may eventually passed onto end-consumer.
3. Built-In Inflation
Built-in inflation, also known as wage inflation, it refers to a self-perpetuating cycle where past inflation expectations lead to price increases. It often originates from wage increases that are passed on to consumers through higher prices for goods and services.
This type of inflation occurs when workers anticipate future price increases and negotiate higher wages accordingly.
As businesses then increase prices to cover higher labor costs, consumers, in turn, expect further inflation and may demand higher wages, perpetuating the cycle.
Built-in inflation reflects how expectations of future inflation can influence current economic behavior and price levels
Effect of Inflation
Whenever we hear the term “inflation”, many of us may feel concerned or anxious about its implications. The truth is, they can be both positive and negative depending on the context and severity. Here is what we can see from negative side:
Eroding Purchasing Power
Inflation generally means that the purchasing power of our money is eroded over time. As consumers, this means our money can buy fewer goods and services than before. While with high inflation, this can significantly reduce the standard of living for consumers.
Economic Uncertainty
High or unpredictable inflation can create economic uncertainty as it make consumers and businesses difficult to plan for future expenditure and investment. When inflation get out of control, this may lead to extended economic issues.
However, from an economic perspective, inflation is also seen as a natural part of healthy economic growth and has it positive effect because it encourages spending and investment. Central banks often aim for a moderate level of inflation to stimulate economic activity.
For instance, most major global economies, including the Federal Reserve, are targeting an inflation rate of 2%. It is worth noting that this doesn’t mean controlling it to be within 2% or lower is better, but rather maintaining it stably near 2% over the long term—neither too high nor too low. Here’s why from economic perspective:
Encouraging Spending and Investment
When consumers anticipate price increases, they tend to make purchases sooner rather than later, or they invest their money. This behavior stimulates consumption and investment activities, thereby boosting economic activity and supporting employment.
Avoid Risk of Deflation
Deflation happen when consumers and business reduce the spending significantly due to certain factors, and this can be harmful to the economy as it discourage spending and investment, leading to economic stagnation and recession.
Overall, targeting moderate inflation at 2% is often viewed as ideal for fostering healthy economic growth without significantly eroding consumers’ purchasing power as high inflation would.
Inflation and Interest Rate
In order to achieve the ideal inflation of 2%, most central banks often would adjust the monetary policy tool – primarily the interest rates in response to that. Therefore, the inflation is often closely linked to the interest rates in a country or region.
Inflation growth rate and long-term trends are crucial data that central banks use to determine monetary policy (raising or lowering interest rates). The relationship between inflation and interest rate is illustrated as below:
The logical relationship between inflation and interest rate cuts is exactly the opposite of the above. When economic growth slowdown or even in recession (often accompanied by low inflation or deflation), central banks will lower interest rates to stimulate economic growth and inflation.
Inflation & Foreign Exchange
Interest rates are key drivers in all financial markets, and inflation is the most important reference indicator for central banks when determining benchmark interest rates. Therefore, inflation significantly impacts all financial markets, including stocks and foreign exchange. The manner and extent of inflation’s impact can vary depending on the specific economic environment:
- When inflation remains stable and close to the target, it will not be a market focus, and its impact on the market is usually very limited.
- When inflation deviates significantly from the set target for a prolonged period, it becomes a focal point for the market, and the latest inflation data can have a significant impact.
Let’s take the example of the EUR/USD exchange rate after the COVID-19 pandemic to illustrate how inflation affects the foreign exchange market.
In the chart below, the lower part shows the EUR/USD exchange rate after the global outbreak of COVID-19 in March 2020, while the upper part features the blue line representing the annual US inflation rate and the yellow line representing the US benchmark interest rate.
It is evident that, except for the period from March 2020 to May 2021, there is an inverse relationship between EUR/USD and US inflation. After May 2021, US inflation has had a decisive impact on the long-term trend of the EUR/USD exchange rate.
When inflation trends upwards and significantly exceeds the 2% target, the market expects US interest rates to rise sharply, leading to a strengthening of the USD over the long term. Conversely, when US inflation trends downward for a long period, the USD begins to weaken over the long term.
