What is Inflation?
Inflation is the rise in prices of goods and services in an economy over a period of time, and is often displayed in percentage form. For example, if inflation is 2%, this suggests that prices are (on average) 2% higher than the previous period. Therefore, if a bottle of water cost $1 last year then this year it should be around $1.02. Inflation can result in significant costs to an economy as the purchasing power of individuals fall.
Deflation is the opposite of inflation where prices fall. This suggests low demand for goods and services and often leads low interest rates. Deflation is atypical amongst developed countries.
Stagflation vs Hyperinflation
Stagflation occurs when an economy is stagnant (low growth) but inflation is still prevalent. This can occur when external factors impact an economy such as the price of oil.
Hyperinflation is an extremely high rate of inflation within an economy. Hyperinflation can be caused by an increase in money supply which consequently results in increased consumer spending and higher demand for goods and services.
Both deflation and hyperinflation can be detrimental to an economy and can result in higher rates of unemployment and lower growth. This makes the role of central banks critically important to control inflation as a lack of stability may have the potential for destructive penalties.
Consumer Price Index (CPI)
This is one of the more common ways of measuring inflation, calculating inflation is based on a basket of goods and services which are often referred to as a ‘cost-of-living index’. Common cost-of-living indexes are the Consumer Price Index (CPI) and Retail Price Index (RPI). These measures relate to inflation experienced by consumers on a daily basis. Each central bank faces unique headwinds in selecting appropriate items to include within their inflation calculation.
Core CPI vs Headline CPI:
Two common phrases when dealing with inflation is ‘core’ and ‘headline’ CPI. This differentiating factor between the two terms is quite simple. Core CPI refers to the omission of food and energy prices from the Consumer Price Index while headline CPI includes both food and energy prices.
Producer Price Index (PPI)
The Producer Price Index (PPI) focuses on inflation at the early stages of production which can provide essential information for manufacturers and industry. The chart below shows the historical comparison between the different inflation measures (CPI, PPI and GDP Deflator). It is clear that PPI is the most volatile which can be explained in part by producers being unable to pass on relatable costs to the consumer in difficult periods such as the global financial crisis.
Another way to measure inflation is via the GDP deflator which takes into account domestic goods only while CPI and/or RPI includes foreign goods, as well. A second key difference is that the GDP deflator method encompasses all goods and services while CPI and/or RPI only measures the price of goods and services bought by consumers. Because the GDP deflator is not restricted by a fixed basket of goods, it has an advantage over the others.
GDP Deflator = (Nominal GDP/Real GDP) x 100
Each measure has bespoke properties that may appeal to different individuals. Therefore, there is no ‘best’ way to calculate inflation but rather each measure has unique aspects that will be suited for different requirements and applications.
PPI vs CPI vs GDP Deflator
Source: World Bank
Sources of Inflation
Inflation can begin via many avenues in isolation or combination. Below are a few of the primary sources of inflation that can distress any nation across the globe:
A weakening local currency means that more local currency is required to purchase imports. This increased cost gets passed on to the end consumer which can contribute to inflation.
Essential Commodity Prices
Most manufacturers require inputs to produce a certain good. These often come in the form of commodities such as iron ore or oil. If these inputs increase in price due, then those costs can be passed on to consumers and the higher costs are a form of inflation.
Lower interest rates theoretically lead to more spending by consumers, ultimately resulting in greater demand and cost of goods; which should lead to inflation, all factors held equal.
Increases in government debt may infer that there is a greater potential of a government default, which leads to higher yields on treasury securities to compensate potential investors for the higher risk. The effect this has on the public is that more tax revenue will be allocated to the higher interest payments on government debt obligations which reduces living standards. Businesses in turn increase the prices of goods and services to offset the lessened government expenditures, and this can lead to inflation.
The sources listed above generally fall into two broad categories of inflation which are:
- Demand-Pull Inflation – This type of inflation comes as a result of an increase in aggregate demand inclusive of households, governments, foreign buyers and businesses.
- Cost-Push Inflation – Supply is the driver of inflationary pressure for cost-push inflation. When supply falls due to higher production costs, the outcome is higher final prices for consumers.
Consequences of Inflation
Value of Money
The most obvious penalty of inflation from a consumer point of view is the higher cost of goods and services. This translates to a decrease in the value of money as individuals can now purchase fewer goods and services with the same amount of money prior to an inflationary rise.
The inequitable distribution of inflationary pressure amongst individuals can lead to changes in wealth. For example, individuals with loans during periods of high inflation will benefit as the real value of their debt repayments will fall over time while others may not.
Fluctuating or erratic inflation data complicates business operations as businesses do not know where to set prices, and this can have a negative effect on the economy as both businesses and consumers adjust to the higher rates of inflation. Long-term business deals will also incur higher costs as volatile inflation causes a higher risk premia on hedging costs, which can reduce foreign investor confidence.
Central banks use of Inflation Targeting
Inflation targeting is quite simple in theory as involves a central bank setting a specific inflation goal in percentage terms. This strategy is achieved by manipulating monetary policy. The goal of inflation targeting allows central banks along with the public to have more clarity in terms of future expectations. The reason behind inflation targeting is control with regards to price stability, and price stability can be attained by governing inflation.
Generally an inflation target of 1% - 2% is familiar as it allows governments and central banks some flexibility at this low base. As a rule of thumb, any deviation greater than 1% either side of the targeted figure is cause for concern and has generally lead to policy intervention.
How do Governments Control Inflation?
There are many ways governments go about controlling inflation which can have knock-on effects (positive and negative) to the economy depending on current economic conditions. The most common way is via contractionary monetary policy which is used by central banks to curb inflation by restricting liquidity. This is achieved via 3 main avenues:
1. Decrease Money Supply
Decreasing money supply simply gives consumers less money to spend overall and should help limit inflation. One way this can be realized is by increasing interest on sovereign bond payments which can attract more investors to buy bonds.
2. Reserve Constraints
Restricting the amount of money banks are allowed to keep can influence the amount of money being lent to consumers. That is, if banks are required to keep higher amounts of money as a legal threshold, then naturally banks will have less money to lend. This should decrease consumer spending and thus, inflation.
3. Raising Interest Rates
Higher interest rates which result in fewer individuals willing to borrow and therefore leads to a decrease in spending. There’s also a greater opportunity cost of investing capital into a business given the higher rates of return that could be had through capital markets.
Global Inflation and Key Relationships
Advanced vs Developing Economies
Source: World Bank
The chart above shows a consistent and logical pattern whereby the historical inflation rate in developed countries is generally less than emerging and developing economies (EMDE).There are two primary reasons behind this:
- EMDE generally have higher growth rates which can lead to excess demand.
- Volatile currencies are present in many EMDE which makes central banks’ management of monetary policy more difficult than those in advanced economies.
The Phillips Curve
The historical relationship between unemployment and inflation has been largely inverse which means that high levels of unemployment correlates with lower inflation and vice versa. The reason why the inverse relationship exists is best explained with basic economics. For example, an increase in aggregate demand which is a consequence of demand-pull inflation, results in higher prices of goods and services and lower unemployment. This lower unemployment means that there is more income available in the economy to spend on goods and services. Both elements have recurrent effects on one another and is best represented by the basic Phillips Curve (see chart below).
Source: Created by Warren Venketas
This article has demonstrated the wide reaching implication of inflation from more concentrated effects to wide-ranging systemic global impacts. Inflation is an important economic tool from a macroeconomic perspective but also can be powerful if understood and implemented within a trading strategy as inflation data can cause changes in price in many financial markets.
Keep track of interest rate decisions by visiting our Central Bank Calendar
NFP and Forex: What is NFP and How to Trade it
Read our article on how Interest rates affect Forex
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.