What is Inflation?

Inflation refers to the gradual increase in the prices of goods and services within an economy over a specific period of time. It is often measured in percentage form, indicating the percentage increase in prices compared to the previous period. For example, if the inflation rate is 2%, it means that, on average, prices have increased by 2% from the previous period. This means that if a bottle of water cost $1 last year, it would now cost around $1.02. Inflation can have significant implications for an economy as it reduces the purchasing power of individuals.

Deflation

Deflation is the opposite of inflation and refers to a decrease in the overall price level. It occurs when the demand for goods and services is low, leading to a decline in prices. This can often result in a period of economic contraction and is considered atypical among developed countries.

Stagflation vs Hyperinflation

Stagflation occurs when an economy experiences stagnant economic growth, characterized by low or no growth, combined with inflation. This can happen when external factors such as changes in the price of oil impact the economy and lead to increased costs.

Hyperinflation, on the other hand, is an extreme form of inflation characterized by an extremely high rate of inflation within an economy. It can be triggered by a sudden increase in the money supply, which in turn stimulates consumer spending and raises the demand for goods and services. Both deflation and hyperinflation can have detrimental effects on an economy, leading to higher rates of unemployment and lower economic growth. Consequently, central banks play a critical role in controlling inflation to maintain stability and avoid these negative consequences.

Measuring Inflation

To accurately assess and monitor inflation, various measures and indices are used:

Consumer Price Index (CPI)

CPI is one of the most common methods used to measure inflation. It calculates inflation based on a basket of goods and services, often referred to as a “cost-of-living index.” Examples of cost-of-living indexes include the Consumer Price Index (CPI) and Retail Price Index (RPI). These measures reflect the inflation experienced by consumers on a daily basis. Each central bank selects specific items to include within their inflation calculation, based on their unique economic circumstances.

Core CPI vs Headline CPI

Two commonly used phrases in relation to CPI are “core” and “headline” CPI. The difference between these terms is relatively simple. Core CPI excludes food and energy prices from the Consumer Price Index, while headline CPI includes both food and energy prices.

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Producer Price Index (PPI)

The Producer Price Index focuses on inflation at the early stages of production, providing crucial information for manufacturers and industries. This index tends to be more volatile than others, partially due to producers being unable to pass on related costs to consumers during difficult periods, such as the global financial crisis.

GDP Deflator

PPI vs CPI vs GDP Deflator

Another measure of inflation is the GDP deflator, which considers domestically produced goods only. In contrast, CPI and RPI include both domestic and foreign goods. Additionally, the GDP deflator encompasses all goods and services, while CPI and RPI calculate the price of goods and services bought only by consumers. The advantage of the GDP deflator is its flexibility, as it is not limited by a fixed basket of goods.

PPI vs CPI vs GDP Deflator

The following chart, sourced from the World Bank, compares the historical data of different inflation measures: CPI, PPI, and GDP Deflator. It illustrates the volatility of the PPI measure, which can be attributed, in part, to producers’ difficulty in passing related costs to consumers during challenging economic periods, such as the global financial crisis.

Sources of Inflation

Inflation can be triggered by several factors or a combination of them. Some primary sources of inflation include:

Exchange Rates

A weakening local currency necessitates more currency to purchase imports. This increased cost is then passed on to end consumers, contributing to inflation.

Essential Commodity Prices

Manufacturers often require inputs to produce goods, and these inputs can be commodities such as iron ore or oil. If the prices of these inputs increase, the costs are passed on to consumers, leading to higher prices and contributing to inflation.

Interest Rates

Lower interest rates theoretically encourage more consumer spending, ultimately resulting in greater demand and higher prices for goods. This increased cost of goods can contribute to inflation.

Government Debt

Increases in government debt can raise concerns about potential government defaults. This leads to higher yields on treasury securities, compensating potential investors for the increased risk. The higher interest payments on government debt obligations reduce living standards, and businesses may increase the prices of goods and services to offset decreased government expenditures, resulting in inflation.

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The sources mentioned above can generally be categorized into two broad categories of inflation:

  • Demand-Pull Inflation: This type of inflation occurs due to an increase in aggregate demand, including from households, governments, foreign buyers, and businesses.
  • Cost-Push Inflation: Supply is the driver of inflationary pressure in cost-push inflation. When supply decreases due to higher production costs, the result is higher prices for consumers.

Consequences of Inflation

Inflation has various consequences and impacts on the economy and individuals:

Value of Money

The most noticeable consequence for consumers is the higher cost of goods and services, which reduces the value of money. Individuals can purchase fewer goods and services with the same amount of money compared to a period of lower inflation.

Wealth Gaps

Inflation can lead to changes in wealth distribution among individuals. For example, individuals with loans during periods of high inflation can benefit as the real value of their debt repayments decreases over time. On the other hand, others may not experience such benefits.

Inflation Volatility

Fluctuating or erratic inflation data complicates business operations, as businesses struggle to set stable prices. This volatility can have a negative effect on the economy as both businesses and consumers struggle to adjust to the higher rates of inflation. Long-term business deals can incur higher costs due to volatile inflation, leading to increased risk premia on hedging costs, which can reduce foreign investor confidence.

Central Banks’ Use of Inflation Targeting

Central banks utilize inflation targeting as a strategy to maintain price stability. This involves setting a specific inflation goal in percentage terms and manipulating monetary policy to achieve the desired inflation level. Inflation targeting provides clarity to both central banks and the public, allowing for better anticipation of future expectations. Typically, an inflation target of 1% to 2% allows for some flexibility while maintaining stability. Any deviation greater than 1% on either side of the targeted figure is generally cause for concern and may require policy intervention.

Advanced vs Developing economies

How Governments Control Inflation

Governments employ various methods to control inflation, and the chosen approach can have both positive and negative effects on the economy, depending on the current economic conditions. The most common way governments control inflation is through contractionary monetary policy, which aims to restrict liquidity and curb inflation. This is achieved through three main avenues:

The Phillips Curve

1. Decrease Money Supply: By reducing the overall money supply available to consumers, governments limit spending, which helps to limit inflation. This can be done by increasing interest rates on sovereign bond payments, attracting more investors.

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2. Reserve Constraints: Governments can impose restrictions on the amount of money banks are allowed to keep, thereby influencing the amount of money available for lending. If banks are required to maintain higher reserves, they will have less money available for lending, decreasing consumer spending and, consequently, inflation.

3. Raising Interest Rates: Higher interest rates discourage borrowing and decrease spending. The opportunity cost of investing capital in businesses increases due to higher rates of return available through capital markets.

Global Inflation and Key Relationships

There are notable differences in inflation rates between advanced economies and developing economies, as shown in the previously mentioned World Bank analysis. Developed countries tend to experience lower inflation rates compared to emerging and developing economies. This discrepancy can be attributed to two primary reasons:

  • Emerging and developing economies generally have higher growth rates, leading to excess demand.
  • Many emerging and developing economies have volatile currencies, making it more challenging for their central banks to manage monetary policy compared to the central banks of advanced economies.
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    The Phillips Curve

    The historical relationship between unemployment and inflation has shown an inverse correlation. This means that high levels of unemployment are associated with lower inflation rates, and vice versa. This inverse relationship can be explained using basic economic principles. For example, an increase in aggregate demand, which results in demand-pull inflation, leads to higher prices for goods and services and lower unemployment rates. The increase in employment means more income is available in the economy for spending on goods and services. These elements have recurring effects on each other and are well-represented by the basic Phillips Curve.

    Inflation: Conclusion

    Inflation is a crucial economic concept that carries wide-ranging implications, from individual consumer effects to systemic global impacts. Understanding and effectively managing inflation is vital both from a macroeconomic perspective and as a consideration within trading strategies, as inflation data can influence price changes across financial markets.

    Further Reading

    To stay informed about interest rate decisions, visit our Central Bank Calendar.

    Learn more about NFP (Nonfarm Payrolls) and how it influences Forex trading.

    Read our comprehensive article on how interest rates affect the Forex market.