The effects of inflation on the economy

A comprehensive look at what inflation is, how it impacts the economy, why it matters to traders, and how to make trading decisions using inflation data.

Investors consider a number of factors when making decisions on where to invest their money. One of the most important factors they consider is the economic well-being of the country they wish to put their investment into. To determine the performance or health of an economy, they consider a number of data pointswhich include the unemployment rate, consumer and business confidence, interest rates, and inflation among others. Ideally, they want to invest in a country that is creating jobs, where there is a high rate of confidence, and where inflation is controlled.

What is inflation?

Inflation is a situation where the price of products is rising. As the rate of inflation increases, the underlying value of the local currency is affected. For example, if you have $100, you can buy a full shopping basket in a local store. If the rate of inflation increases by 5% in one year, the $100 will not fill your shopping basket when you go shopping.

As a result, according to the inflation calculator provided by the US Bureau of Statistics, a $100 note in 2000 had a buying power as $150 in September 2018. A $100 note in 1950 had the same buying power as $1074 in September 2018.

Well-maintained inflation in a country is important because it helps companies grow their margins. As they expand the margins, the companies can continue to hire more people.

The opposite of inflation is known as deflation. This is a situation where the price of products is declining. For example, if the price of gasoline falls by $10 in one year, the consumers can use the savings to buy other things. However, a steep rate of deflation is dangerous to an economy because companies will make less money per unit, have challenges paying their debt obligations, and then lay off workers leading to an increase in the national unemployment rate.

Another important concept is hyperinflation. This is a situation where a country’s rate of inflation raises by more than 50% in a given month. This is a dangerous situation because it causes the local currency to lose its value and makes ordinary products unaffordable to consumers.

Finally, there is the concept of stagflation. This is a situation where a country’s economic growth is slowing and is then accompanied by a growing unemployment rate and high rate of inflation. This is common in oil exporting countries and happens mostly when the price of crude rises. This leads to a slow growth in these countries and high prices of products. The latter comes as the rising crude leads to high transportation and production costs.

Causes of inflation

There are a number of causes of inflation. These include:

  • Money Supply: This is a situation where a country’s central bank increases the amount of money in circulation. A good example of this is in a country like Zimbabwe, which printed money to boost growth. The result of this was hyperinflation made the local currency valueless.
  • Monetary Policy: This refers to the monetary policy decisions made by central banks. Lowering interest rates is a way of boosting the money supply and it leads to a higher inflation. Tightening, on the other hand, means limiting the supply of money. The central bank can also devalue its currency in a bid to boost exports. In doing so, the prices of goods can increase.
  • Increase of taxes: To fund investments, countries can increase taxes on products. When this happens, the price of the goods tends to move up.
  • Demand and supply dynamics: The price of products can move up and down depending on the demand and supply dynamics. If there is a constrained supply of key commodities like crude oil, the result can be higher consumer prices.
  • Economic growth: The growth of an economy can lead to higher inflation. The Philips curve is often used to explain this. It says that the rate of inflation tends to rise when the unemployment rate is falling.

Important measures of inflation

To know the rate of inflation, traders use the economic calendar. In the calendar, they look at a number of economic indicators. These are:

  • Consumer Price Index (CPI): This is a number that shows the average change in the price of goods and services in an economy.
  • Core CPI: This is a number that shows the change of the average price of goods and services while excluding the volatile energy and food products.
  • Producer Price Index (PPI): This is a measure of the change of prices of goods received by domestic producers.
  • Retail Sales: These are numbers that show the growth of retail sales in the country. Increasing sales show that the rate of inflation is likely to move up.
  • Employment numbers: As described above, the Philips curve is a concept that compares the rate of inflation to that of jobs numbers. As the employment improves and as the unemployment rate falls, the rate of inflation is usually expected to increase.

Why the inflation rate matters to traders

To traders, the rate of inflation is very important when making the decision on whether to buy or sell a currency. This is mostly important because of the role of the central banks in influencing the interest rates of a country.

One role of the central bank is to ensure price stability of products in a country. Therefore, when the rate of inflation increases, the central bank often moves to raise interest rates. They do this to limit the overall supply of money. This is mostly because when rates are high, more people and companies will avoid borrowing. When this happens, the local currency tends to strengthen as its supply becomes limited.

On the other hand, when the inflation rate falls, the central bank tends to lower interest rates. They do this to make money readily available to people and companies. This leads to more spending, which leads to a higher rate of inflation. However, this does not always happen. For example, after the financial crisis of 2008/9, the Bank of Japan lowered rates in a bid to increase inflation. When it failed to happen, the bank decided to push rates to the negative territory. Even after doing that, the country continued to experience slow inflation growth even with the improving economic growth. This is mostly because most Japanese prefer saving to consumer spending.

Therefore, the main reason why traders pay close attention to a country’s inflation rate is because of the central bank. The local currency of a country whose inflation rate is rising tends to strengthen because traders usually anticipate tightening from the central bank. Similarly, the currency of a country with low – and falling inflation – tends to remain lower because it is almost impossible for a central bank to tighten under these conditions.

How to trade using interest rates

If you are a trader who specializes in fundamental analysis, the rate of inflation is very important and you can use it in a number of ways.

First, when the jobs numbers show a falling unemployment rate and a general improvement in employment, traders believe that it will lead to a high rate of inflation, which will lead to high interest rates. High-interest rates can lead to a stronger currency and higher bond yields. Higher bond yields, on the other hand, leads to lower stock prices as investors rotate from stocks to bonds. In this case, you can buy the country’s currency and short the country’s stocks and indices.

Second, inflation numbers create opportunities for carrying trade opportunities. A carry trade is a strategy that involves borrowing money at low interest rates and using the funds to buy a better-yielding asset. In forex, it works by buying a currency that is in low or negative interest rates and using the funds to buy a better-yielding currency. The goal in this is to earn the spread in interest rates and also to see the value of the currency they bought rise. A good example of a good pair for carrying trades is the USD/JPY. This is because the US federal funds were at 2.25% in September 2018 while the BOJ rates were at minus 0.1%.

Third, if the central bank has not provided a forward guidance on interest rates, the CPI and PPI numbers can help you forecast about the future of rate hikes. If the CPI shows continued growth of inflation, it is an indication that the central bank will likely raise rates. Alternatively, if the CPI numbers are decreasing, the forecast is that of lower interest rates. With this knowledge, you can buy the local currencyif you believe their value will rise or short them if you believe they will decline.

Inflation numbers as an opportunity

A good thing about the forex market is that you can either buy currency pairs or short them. When you buy a currency pair, you are hoping that the value of the base currency will increase against the quote currency. When you short, your hope is that the value of the base currency will decrease. Therefore, the inflation numbers can help you make an informed decision about the future of the currency pairs.

Source   Presented by OctaFXForex Columns
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