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20 - Inflation
Up to this point we have mentioned the term “Inflation” many times. However, we have only given you a simplified definition of what it is. Now what we are going do in this lesson is dig a little bit deeper and pack on some more information to fill up any gaps that you may have with inflation.
In this Article:
- Inflation Introduction
- What is Inflation?
- What does Inflation do?
- Why is Inflation Important?
One of the most important concepts in the Forex market is that of inflation and deflation. Basically, a central bank will do everything in its power to keep the prices of goods and services rising within the economy. However, they would obviously prefer that inflation moved higher in a gradual and stable manner while avoiding big price spikes in either direction.
If prices rise just enough then it encourages growth and spending within the economy. This is because people know that in a years’ time the good or service that they want to buy will likely be more expensive than it is now, so they might as well buy now and get a better deal. Why wait a year when you can get your thing now and spend less?
Stable inflation is the ideal situation that all major economies would like to have. If this is the case then the markets will likely deem the economy as investment grade which is overall a very positive thing. Investment grade simply means that market likes the economy and feels that it is safe and worthwhile to invest their money in.
What is Inflation?
Generally speaking, inflation is the percentage rate at which the level of prices for goods and services are rising within a particular economy. Ok, so if the price of stuff is going up then we have an inflationary environment….Seems simple enough?
What this is really telling us is that the purchasing power of the local currency is falling over time when inflation is present. For us normal people, this means that our money next year will be worth less than it is today.
Inflation is usually measured by using the Consumer Price Index (CPI) data year over year because this tells us how much more or less consumers are paying for the stuff they need.
What does Inflation do?
As a result of inflation, the purchasing power of a single unit of currency falls within a particular economy.
For example, if the current rate of inflation is 3%, then a basic consumable item that costs $1 today will cost $1.03 next year.
As goods and services require more money to purchase, the value of that money falls. If the wages of the nation’s citizens are not increasing at the same rate as inflation then this puts extra cost pressures on households to find alternate ways to be able to keep buying the stuff they need. Typically, this means that regular households need to go into debt. In a situation such as this the purchasing power of the nation’s citizens is going down which is obviously not a good thing.
This situation highlights why jobs data is typically a major driving factor for how central banks will attempt to manage the economy. The point is to have stable inflation while the economic prosperity for the nation’s citizens continues to increase with rising wages.
The most ideal situation for a central bank is to have inflation and wage growth in line with each other. The job of the central bank is to limit inflation, and avoid deflation, in order to keep the economy running smoothly. Central banks in most developed economies aim at roughly 2% inflation per year with a slight bit of flexibility above or below that rate.
If the central bank is targeting 2% inflation per year and inflation gets to 3% this may not be too big a deal overall. However, if inflation gets to 5, 10 or 15% then this can really have a large negative impact on people’s lives. This creates a situation such as hyperinflation which will effectively destroy the economy and ruins the value of the local currency. We will have a separate article to explain hyperinflation in an upcoming lesson.
Why is Inflation Important?
Simply put, it tells us how the economic prosperity for the people of one country is doing compared to another country. Too much inflation can be a negative thing but so can too little inflation. This is why the central bank is there to try and balance growth so that their countrymen can have continued prosperity compared to other countries but not fall behind. Falling behind would mean that the country as a whole is less competitive which is not good for economic prosperity.
Now that we know all about inflation it’s time to turn our attention to inflation's evil cousin…..the deflation!