A Guide to Understanding Inflation and How It Affects Traders

Updated March 17, 2022 GuidesLatest ReleaseTrending

Inflation is becoming an increasingly important factor in our everyday lives. Google searches are up, and it has reasserted itself as a topic of popular conversation. Traders are having to familiarise themselves with how inflation affects financial markets.

Discover what inflation is, why it matters and how it impacts policymaking.

What is inflation?

In very simple terms, inflation is the rate at which prices rise. It’s when things cost more than they used to.

Let’s say a trip to the grocery store last year cost you $100. One year later, that same “basket” cost has risen to $105. This would be reported as a 5% year-over-year price change, or 5% inflation.

In effect, inflation reduces our purchasing power over time. This is because it means that every dollar you have buys less tomorrow – be it bread, rent, or medical services.

The fact that goods cost more than they once did, isn’t inherently good or bad. But it does have a very real impact on your money, businesses, and economies.

What causes inflation?

Rising inflation is essentially down to the age-old battle between supply and demand. You might read about more technical terms like “cost-push” and “demand-pull” inflation.

Companies may see that the cost of raw material is rising, so they have to raise their prices to compensate. Higher costs are pushing the price of the things we buy higher.

Take your smartphone and think about the many different parts used to produce it.

If we assume the cost of the battery or the microchip inside increases in price,.

Eventually, those higher prices will be passed on to the consumer. When our demand to purchase things is greater than what companies can supply, we may pull the price higher. People might have a lot of surplus cash or are accessing credit and want to spend. Businesses may need to raise prices because they lack adequate supply. That gives rise to inflation.

Is inflation good or bad?

The good: Low and steadily rising prices are typically brought about by a healthy economy. Stable inflation ensures a modern economy can continue to benefit from an efficient allocation of resources.

– Rising prices create an incentive to buy more things today. This leads to higher demand which boosts consumer spending and drives economic growth. This can also improve productivity.

– Central banks – and government policy in general – retain a cushion against falling prices to respond to unforeseen events. This may help reduce the severity of a potential downturn.

– Savers get a reasonable interest rate on deposit accounts. Borrowers are not overly incentivised to take on more debt.

In fact, debts may be paid off with money that is worth less than it was before. Imagine a vendor who sells a product for $10 and owes the bank $200 today. But next year, the seller can charge $15, while the debt remains the same. This means it becomes easier to pay back.

The bad: Inflation reduces how much each dollar is worth. Higher inflation therefore means consumers get less for their money.

– When inflation rises, the cost of living goes up. If this is not offset by higher wages in the short term, households and consumer activity can suffer as discretionary spending is reduced.

– If prices rise too high, interest rates may rise. This can hurt savers as inflation diminishes the value of the interest you earn on your deposits.

– Investors may also lose out due to rising prices. This is because interest rates may increase, which typically results in a decrease in the price of fixed-rate securities like fixed-rate bonds and government bonds.

How is inflation measured?

The most popular measure of inflation is produced by the US Bureau of Labour Statistics (BLS) which tracks and calculates a representative group of things consumers spend their money on, known as a ‘basket’. The widely followed Consumer Price Index (CPI) is the monthly expenses for an average US household and includes housing, transportation and food prices.

“Core” CPI strips out food and energy costs which are traditionally more volatile.

Inflation is a backward-looking figure and doesn’t forecast the future and how long inflation might last. The highest rate of inflation in the US since the introduction of CPI was 19.66% in 1917. A record low printed in 1921 of -15.8%. The 1970s saw the longest period of sustained high inflation rates. The Russia-Ukraine crisis has seen CPI hit multi-decade highs, with the CPI rising 7.9% in February 2022 compared to the previous year.

How does inflation affect policies and interest rates?

Keeping inflation levels stable and consistent (“price stability”) is the responsibility of central banks. They will generally have an inflation target around 2% and can bring about change by adjusting its monetary policies and interest rates.

– If inflation drops below target over the medium-term, policymakers might lower interest rates to boost the economy. This will encourage consumers and businesses to borrow money at lower rates to get the economy back on track. This should boost retail and capital spending.

– If inflation goes too high, the central bank could raise rates to try and slow the economy. Higher interest rates normally force consumers and businesses to borrow less and save more, dampening economic activity. 

Investors also need to understand that certain asset classes will perform better as they can act as a hedge against high inflation. Common assets that are more likely to be protected against inflation include gold, commodities and real estate investments.

Gold can behave like an ‘alternative currency’ in times of high inflation, especially when it is a component of a diverse portfolio.

Commodities are key inputs into CPI and may act as a forward-looking measure of inflation. When the price of a commodity rises, so will the cost of the products that the commodity is used to produce.

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