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FX 101: What is inflation?

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2 June 2023

Written by
Matthew Ryan

Head of Market Strategy at Ebury Providing expert currency analysis so small and mid-sized businesses can effectively navigate international markets.

This episode and article will cover:

  • Definition and explanation of inflation
  • Measurement of inflation
  • Types of inflation
  • Terminology related to inflation
  • Importance of inflation data and central bank’s role

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Read the full transcript:

What is inflation?

Simply put: Inflation is the rate at which the general level of prices for goods and services changes over time. Nice and easy.

There are a range of ways in which inflation is measured, whether that be the CPIH, which includes housing costs, the Retail Price Index (RPI), that includes factors such as interest rate payments on mortgages and council tax. We also have the Personal Consumption Expenditures measure, or PCE index, which is the favoured metric of the US central bank – the Federal Reserve. There’s also the PPI, known as the producer price index, which measures the change in producer prices over time.

But, the main and most widely used measure of inflation globally, and the one that is most closely followed by governments, central banks and financial markets, is the Consumer Price Index, or CPI. But what is CPI? Well this index measures the change in prices paid by consumers for a weighted basket of goods and services. This ‘basket’ is periodically updated (in the UK at least, on an annual basis) in order to ensure that it reflects the latest consumer spending habits.

So each year, we see the inclusion of new items that represented a larger share of household consumption in the previous year, and a flushing out of items from the index that are perhaps no longer relevant. So for instance, in the UK last year, items including doughnuts, men’s suits and coal were all removed from the index, while meat-free sausages and frozen Yorkshire puddings (believe it or not), were added.

The change in the overall price of this basket is then computed relative to the previous month, and previous year, giving investors both month-on-month and year-on-year data to digest.

There are also two different CPI measures. First of all, we have the headline index, or headline inflation, which refers to the change in value of all goods in the basket. We then have the measure of core Inflation. This is typically far less volatile than the headline number, as it excludes items such as food and energy, which tend to experience greater fluctuations in prices. In recent months, this core inflation measure has taken on far greater importance for economists and central bankers, given the volatility experienced in energy prices in particular, notably natural gas, following Russia’s invasion of Ukraine in early-2022.

What drives changes in prices in an economy and influences the level of inflation?

Well there are 3 primary types of inflation.

First of all, we have Demand-Pull Inflation: This is caused by strong consumer demand for a product or service, and tends to happen when unemployment is low and wages are rising, or after tax cuts, i.e when disposable incomes and spending are high. Demand increases and the available supply decreases, so consumers are willing to pay more for the product.

The second type of inflation is called Cost-Push Inflation: This occurs when prices rise due to increases in production costs, such as raw materials, wages or rent. Due to these higher costs of production, supply declines, and prices increase. These added costs are then passed onto consumers in the form of higher prices of finished goods.

Lastly, we have something known as built-In Inflation: Now this is something that occurs when enough of the population expects inflation to continue in the future. When individuals expect higher prices, workers will demand higher wages in anticipation of those price increases. When wages go up, that both increases the cost of production to businesses and increases consumer demand, both of which push up inflation and potentially lead to what is known as a wage-price spiral.

Different terminology

Now, there’s a lot of different terminology that is commonly used to describe changes in inflation, so we’re going to break it all down.

First of all, we have deflation. This occurs when price growth is negative, i.e. when prices decline over a period of time, usually during bust periods, or recessions.

Disinflation refers to a slowdown in the rate of inflation, when rates of change in prices ease, but that change remains positive.

Hyperinflation, which is a very rare occurrence, refers to rapid increases in prices in an uncontrolled manner, most famously in Germany during the 1920s or Zimbabwe in more recent times.

One term that has received a LOT of press recently is stagflation. This is another unusual occurrence, that takes place when inflation is high and rising, while economic growth is slowing, or even negative. This typically takes place when there is an external shock to prices, for instance, the recent spike in energy prices induced by Western sanctions on Russia.

Why do central banks have an inflation target?

We talked on the last episode about how central banks will either raise or cut interest rates in order to guide inflation towards their target level. But, why do central banks have an inflation target in the first place? Well, the main benefit is that low and stable inflation allows individuals and businesses to plan for the future, promoting confidence in the economy and fostering healthy economic expansion.

Again, as mentioned last time out, ensuring stable inflation is generally the most important mandate for central banks, and the most important determinant of monetary policy, so inflation data is always heavily scrutinised by investors.

In the vast majority of the major economic areas, inflation data is released on a monthly basis, although in the likes of Australia and New Zealand for instance, the main CPI print is released quarterly. In the UK, we tend to receive the previous month’s print on around the third Wednesday of the following month.

When it comes to the reaction in currencies, we are not just looking at how the data has performed over time, but also how the data performs relative to economists’ expectations. So when investors look at their economic calendars, there are three numbers that they are paying attention to:

  • The previous month’s data.
  • The consensus of economists.
  • And the actual print for that month.

So, the data could come in higher than the previous month, which one could perceive as bullish, but if it falls short of economists’ expectations (i.e the number that is already priced in by markets), then the currency could sell-off.

Is inflation necessarily a bad thing? No, a small amount of inflation is generally perceived as something that can help drive economic growth. But high and uneven price rises that outstrip increases in nominal earnings growth and incomes, can create a real headache for governments and central bankers. And, as we’ve seen in the past year or so, high and entrenched inflation can be a very difficult thing to get rid of.

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