Understanding Inflation and its Global Impact

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What is Inflation?

Inflation is the increase in the prices of goods and services in an economy over a period of time, usually expressed as a percentage. For example, if inflation is 2%, this means prices are (on average) 2% higher than in the previous period. So if a bottle of water was $1 last year, it should be around $1.02 this year. Inflation can take a heavy toll on the economy as the purchasing power of individuals declines

Deflation

Deflation is the opposite of inflation where prices fall. This indicates low demand for goods and services, often resulting in low interest rates. Deflation is atypical in developed countries.

Stagflation vs Hyperinflation

Stagflation occurs when the economy stagnates (low growth) but inflation persists. This happens when external factors affect the economy, such as B. the price of oil.

Hyperinflation is an extremely high rate of inflation in an economy. Hyperinflation can be caused by an increase in the money supply, resulting in increased consumer spending and increased demand for goods and services.

Both deflation and hyperinflation damage the economy, leading to higher unemployment and lower growth. This makes the central bank’s role in controlling inflation crucial, as a lack of stability can lead to damaging penalties.

Measuring Inflation

Consumer Price Index (CPI)

This is one of the more common ways to measure inflation. Inflation is calculated based on a basket of goods and services, often referred to as a “cost of living index”. Common cost of living indices are the Consumer Price Index (CPI) and the Retail Price Index (RPI). These measures are related to the inflation that consumers experience on a daily basis. Each central bank faces unique headwinds when it comes to selecting appropriate items to include in its inflation calculations.

Core CPI vs Headline CPI:

Two commonly used terms when dealing with inflation are “core” and “headline” CPI. The distinguishing factor between these two terms is quite simple. The core CPI refers to omitting food and energy prices in the consumer price index, while the headline CPI includes food and energy prices.

Producer Price Index (PPI)

The Producer Price Index (PPI) focuses on inflation in the early stages of production and provides important information for manufacturers and industries. The chart below shows a historical comparison between different inflation indicators (CPI, PPI, and GDP deflator). Obviously, PPI is the most volatile, in part because manufacturers are unable to pass the corresponding costs on to consumers during difficult times such as the global financial crisis.

GDP deflator

Another way to measure inflation is the GDP deflator, which only considers domestic goods, while the CPI and/or RPI also include foreign goods. The second key difference is that the GDP deflator method includes all goods and services, while the CPI and/or RPI only measure the price of goods and services purchased by consumers. Because the GDP deflator is not constrained by a fixed basket of commodities, it has an advantage over other commodities.

GDP deflator = (nominal GDP/real GDP) x 100

Each measure has tailored attributes that may appeal to different people. Therefore, there is no “best” way to calculate inflation, and each indicator has unique aspects that suit different needs and applications.

PPI vs CPI vs GDP Deflator

Source: World Bank

source of inflation

Inflation can start alone or in combination in a number of ways. Here are some of the main sources of inflation that can plague any country in the world:

exchange rate

A weaker local currency means more local currency is needed to buy imported goods. These increased costs are passed on to end users, which can lead to inflation.

basic commodity prices

Most manufacturers require inputs to produce a specific item. These are usually in the form of raw materials such as iron ore or petroleum. When the prices of these inputs rise, these costs can be passed on to consumers, and higher costs are a form of inflation.

Interest expense

In theory, lower interest rates lead to more consumer spending, which ultimately leads to higher demand and higher cost of goods; this should lead to inflation, all being equal.

national debt

A rise in sovereign debt could signal a greater chance of a sovereign default, leading to higher government bond yields to compensate potential investors for the increased risk. For the public, the result of this is that more taxes are used to pay higher interest on government debt, thereby lowering living standards. Businesses, in turn, raise prices of goods and services to offset reduced government spending, which can lead to inflation.

The sources listed above generally fall into two broad categories of inflation:

Demand-Pull Inflation – This type of inflation is the result of an increase in aggregate demand, including households, governments, foreign buyers and businesses.
Cost-Push Inflation – Supply is the driver of inflationary pressure in cost-push inflation. This leads to higher final prices for consumers when supply falls due to higher production costs.

Consequences of Inflation

Value of Money

From a consumer’s perspective, the most obvious penalty for inflation is the rising cost of goods and services. This causes the currency to depreciate because individuals can now buy fewer goods and services with the same amount of money before inflation rose.

The gap between rich and poor

Uneven distribution of inflationary pressures among individuals can lead to changes in wealth. For example, people who receive credit yields during periods of high inflation because the real value of their debt repayments decline over time, while others may not.

Inflation volatility

Volatile or volatile inflation data complicates business operations because companies don’t know where to set prices, which can negatively impact the economy as both companies and consumers adjust to higher inflation rates. Longer-term trades will also incur higher costs, as volatile inflation imposes a higher risk premium on hedging costs, which could reduce foreign investor confidence.

Central Banks Use Inflation Targeting

Inflation targeting is very simple in theory because the central bank sets a specific percentage of the inflation target. This strategy is achieved by manipulating monetary policy. The goals of inflation targeting give central banks and the public more clarity on what to expect in the future. The rationale for inflation targeting is to control price stability, which can be achieved by managing inflation.

In general, the 1% to 2% inflation target is well known because it allows governments and central banks some flexibility with this low base. As a rule of thumb, any deviation of more than 1% on either side of the target is cause for concern and often leads to policy intervention.

How does the government control inflation?

There are many ways in which governments control inflation, and depending on current economic conditions, inflation can have (positive and negative) effects on the economy. The most common method is contractionary monetary policy, where the central bank suppresses inflation by restricting liquidity. This is achieved in 3 main ways:

1. Reduce the money supply

Reducing the money supply will only allow consumers to spend less and should help curb inflation. One way is to raise the interest rate paid on government bonds, which can attract more investors to buy bonds.

2. Reserve Limits

Limiting the amount banks are allowed to keep could affect the amount of credit they give consumers. That said, if banks are required to hold amounts above the legal threshold, then of course the amount of money banks can lend will be reduced. This should reduce consumer spending, and thus inflation.

3. Rate hikes

Higher interest rates lead to fewer people borrowing, which in turn reduces spending. The opportunity cost of investing capital in a company is also higher, given the higher returns that can be obtained through capital markets.

Global Inflation and Key Relationships

Advanced vs Developing Economies

Source: World Bank

The chart above shows a consistent and logical pattern in which historical inflation rates in developed markets have generally been lower than in emerging and developing economies (EMDEs). There are two main reasons for this:

EMDEs typically have higher growth rates, which can lead to excess demand.
Volatile currencies exist in many emerging market and developing economies, making the management of monetary policy more difficult for central banks than in advanced economies.

The Phillips Curve

The historical relationship between unemployment and inflation is largely inverse, meaning that higher unemployment is associated with lower inflation and vice versa. The reason for the existence of an inverse relationship is best explained by basic economics. For example, demand-pull inflation leads to an increase in aggregate demand, leading to higher prices for goods and services and lower unemployment. This lower unemployment means more income is available in the economy for goods and services. Both elements have repeated effects on each other and are best represented by a basic Phillips curve (see image below).

Source: Created by Warren Venketas

Inflation: Conclusion

This article outlines the broader effects of inflation, ranging from more concentrated effects to far-reaching systemic global effects. Inflation is an important economic tool from a macroeconomic perspective, but it can also be powerful when understood and implemented in a trading strategy, as inflation data can cause price changes in many financial markets.

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