In the world of finance, inflation is a key driver of asset valuations, consumption and consumer sentiment. Traders and investors alike monitor inflation on a daily basis, evaluating its potential impact on the markets. While views toward the phenomenon vary, it is a primary driver of economic progress.
What Is Inflation?
According to the Oxford dictionary, inflation is "a general increase in prices in an economy and consequent fall in the purchasing power of money." In other words, inflation is the average rise in the cost of goods and services over a given period of time.
From a consumer's perspective, inflation means a higher cost of living due to a downturn in the local currency's relative value. Conversely, policymakers view constant, manageable inflation as being an essential part of economic development. In fact, central banking authorities typically view moderate inflation as being a positive attribute. For instance, the United States Federal Reserve (Fed) aims for a long-run goal of 2% to "promote maximum employment and price stability."
Types Of Inflation
Inflation is a complex topic, and the reasons behind the phenomenon are debatable. However, the consensus agrees that there are two basic types of inflation:
Demand-pull inflation occurs when consumer demand for goods and services increases. As consumption grows, producers can charge more for their products. Demand-pull inflation is prevalent during expansionary economic cycles.
Cost-push inflation develops when the supply of goods and services decreases. The subsequent shortage artificially boosts demand, thus producers are able to raise prices. There are many drivers of cost-push inflation, including natural disasters and government regulations.
The impact of inflation on consumers and investments can range from positive to devastating. Generally, a low, constant rate of inflation is seen as beneficial to investors, policymakers and consumers; conversely, sudden spikes in consumer prices present challenges for all.
Two Extreme Types Of Inflation
There are two extreme inflationary scenarios that can severely negatively impact economic prowess. These events are hyperinflation and stagflation:
- Hyperinflation: Hyperinflation occurs when consumer prices rise uncontrollably and rapidly. As a general rule of thumb, hyperinflation is present when inflation rises more than 50% in a month.
- Stagflation: Stagflation is a period where inflation is high and economic growth is low.
History Of HyperInflation
History shows that both hyperinflation and stagflation can wreak havoc on economies. For hyperinflation, there have been several instances over the past century where the circumstance has acted as a wealth destructor:
- 1944, Greece: Amid WWII fallout, the Greek drachma experienced 13,800% inflation during October 1944. Accordingly, consumer prices doubled every 4.3 days.
- 1923, Germany: In October 1923, Germany's Weimar republic saw a monthly inflation rate of 29,500%. This infamous case included a 20.9% average daily rate and prices doubling every 3.7 days.
- 1994, Yugoslavia: Stemming from regional conflict and aggressive governmental borrowing, the Yugoslavian dinar saw 313,000,000% monthly inflation for January 1994. The daily rate came in at 64.6%, with prices doubling every 34 hours.
- 2008, Zimbabwe: During November 2008, Zimbabwe's currency posted a monthly inflation rate of 79.6 billion percent. Prices doubled every 24.7 hours, with the Reserve Bank of Zimbabwe eventually pegging currency values to the USD.
History Of Stagflation
In addition to hyperinflation, stagflation has periodically plagued economies. The most well-known case of stagflation occurred in the United States during the late 1970s. From 1976 to 1980, U.S. gross domestic product (GDP) fell while inflation rates spiked. Over the four-year period, GDP plummeted from 4.4% to 0.1%, while inflation rose from 5.77% to 13.50%. The end products of the 1970s' U.S. stagflationary cycle were elevated unemployment levels, a severe recession and aggressive quantitative tightening from the Fed.
These examples place an impetus on prudent monetary policy. To address these concerns, central banks control the money supply and lending rates on an ongoing basis. In doing so, unfortunate hyperinflationary and stagflationary cycles can be minimised or avoided.
Around the world, there are many different metrics used to measure inflation. A few of the most common are the consumer price Index (CPI), producer price index (PPI) and core personal consumption expenditures (Core PCE).
By referencing these indicators, governments, central banks and investors are able to gauge the relative state of pricing stability. Typically, CPI, PPI and Core PCE rise in concert with increasing inflation.
Consumer Price Index (CPI)
The CPI is the average change in prices paid for a basket of goods and services over a period of time. CPI is an official metric, typically released by a governmental department. Examples of these bodies include the U.S. Bureau of Labour Statistics (BLS) and the U.K.'s Office for National Statistics (ONS).
CPI figures may be released monthly, quarterly or annually. As CPI rises, inflation is perceived to be growing.
Producer Price Index (PPI)
According to the U.S. BLS, the PPI measures the average change over time in the selling prices received by producers for their output. An uptick in PPI may be attributed to several factors, including strengthening demand, rising commodity prices or increased wages.
Like CPI, PPI is an official metric released by bodies such as the BLS or ONS. And, similar to CPI, rising PPI is typically correlated with growing inflation.
Core Personal Consumption Expenditures (Core PCE)
Compared to CPI and PPI, Core PCE is a more involved metric. Produced by the U.S. Bureau of Economic Analysis (BEA), Core PCE measures the change in the prices of goods and services over a broad spectrum of products. The index also includes direct and indirect household spending.
Core PCE is a go-to metric for the U.S. Fed in judging inflation. Values are updated monthly and quantify the current state of consumer prices. Like CPI and PPI, rising Core PCE suggests growing inflation. Similar reports are released internationally, such as the U.K. core inflation rate.
Case Study: COVID-19 Sets Stage For Inflationary Cycle
The COVID-19 pandemic brought unprecedented uncertainty and tumult to financial markets around the globe. During the contagion's initial onset in March 2020, the values of equities, commodities, foreign currencies and cryptocurrencies plunged amid aggressive capitulation. As a result, the USD Index reached multi-year highs above 102.00 as market participants attempted to price-in the influence of COVID-19.
Central Banks And Governments React To COVID
To mitigate the economic damage from COVID-19, central banks around the globe adopted aggressive dovish monetary policies. For the U.S. Fed, the program of "unlimited QE" slashed the Federal Funds Rate to 0.0-0.25% and injected trillions into the U.S. economy. The Fed's actions were adopted by the world's central banks, as evidenced by the European Central Bank (ECB) QE program of US$820 billion and Bank of England (BoE) cutting interest rates to 300-year lows.
On the fiscal front, developed nations launched several of the largest government stimulus programs on record. In the United States, the federal government enacted multiple COVID-19 aid packages, which totalled upwards of US$2.59 trillion. Other countries implemented similar policies, such as U.K. stimulus that approached £300 billion.
Polices Stimulate Inflation
While the dovish monetary and fiscal policies did prompt a swift market recovery from the pandemic, it also stimulated inflation. The spring and summer of 2021 brought a significant spike in global consumer prices. As an illustration, U.S. prices rose precipitously during this period:
- April 2021: Core PCE jumped to 3.1%, the highest annual reading since July 1992.
- June 2021: PPI rose 1.0% in June, rallying 7.3% year-over-year, the largest annual gain in more than a decade.
- July 2021: CPI rose to 5.4% year-over-year, the largest uptick since August 2008.
Given the expansive metrics, many in the financial community viewed persistent inflation as being inevitable. According to a Reuters survey of economists in June 2021, 23 of 38 viewed growing inflation as being the biggest risk to the U.S. economy. In response, traders and investors began seriously addressing the potential impact of impending inflation.
How Impending Inflation Impacts Investment
Inflation has a wide range of effects on different assets and investment vehicles. Due to this variance, traders and investors are well-advised to remain aware of evolving inflation levels and strategise accordingly. The eventual impact of inflation on equities, currency and commodity valuations can be significant.
As a general rule, elevated inflation levels are viewed as being a negative long-term market driver for equities prices. This isn't necessarily true for the short-run, as moderate inflation growth is one indicator of robust economic performance.
To illustrate this point, during the spring/summer 2021 uptick in inflation, the U.S. equities indices performed well. From 1 April 2021 to 1 September 2021, the DJIA (+1997 points, 6%), S&P 500 (+553.7 points, 13.9%), and NASDAQ 100 (+2489 points, 18.9%) all posted solid gains.
However, from a fundamental standpoint, inflation increases the cost of capital, as well as the price of raw materials and labour. As a result, corporate earnings are positioned to fall, which can cause a bearish view of potential growth.
Also, investors account for growing inflation by demanding higher risk premiums. This can accentuate negative market sentiment as achieving the required lofty returns may be deemed improbable. In a study from 2000, Fed member Steven A. Sharpe summed up the inflation/returns dynamic: "market expectations of real earnings growth, particularly longer-term growth, are negatively related to expected inflation."
Forex investment strategies are designed to take advantage of one currency's appreciation to another over time. Inflation plays a huge role in the effectiveness of such strategies for several reasons:
Hamper Economic Performance
An extended period of high inflation raises the cost of doing business and limits consumption. As a result, economic growth can stagnate. Studies have shown that persistent inflation above 10% has been a historic detractor of economic development. As a result, currency values are prone to remain depressed in concert with prevailing economic conditions.
Drive Monetary Policy
One of the ways in which central banks combat inflation and restore pricing stability is through raising interest rates. As a central bank "hikes" rates, the domestic currency strengthens. This is due to a reduced money supply stemming from increased savings and a lessened demand for financing.
By far, one of the largest concerns facing forex investors is inflation. Rising interest rates and depressed economic development are two key currency market drivers that can greatly influence exchange rate valuations.
During periods of rising inflation, commodity products frequently perform well. The reasons for this are twofold:
As an expansionary economic cycle progresses, the demand for raw materials to provide goods and services heightens.
Inflation and currency devaluation also sends commodity prices higher.
In both cases, inflation serves as a bullish commodity market driver.
The COVID-19 market recovery of 2021 illustrates the inflation/commodity correlation. From 1 April 2021 to 1 September 2021, U.S. Core PCE, CPI and PPI grew steadily. In response, commodity values responded positively:
- West Texas Intermediate (WTI) crude oil rallied by US$9.11 per barrel (15.3%).
- Spot gold (XAU/USD) posted a solid gain of US$106.32 per ounce (6.2%).
- Soybean futures rose by US$0.45 per bushel (3.4%).
- Corn futures ticked higher by US$0.46 per bushel (9.1%).
Given the strength shown by commodities during inflationary cycles, many investors view the asset class as an important part of risk management. Through buying and holding physical and derivative commodity products, savvy investors hedge against inflation risk.
Inflation is a complex topic with many causes and effects. For active traders and investors, it is a key economic underpinning to be familiar with. Through monitoring official metrics such as CPI, PPI and Core PCE, market participants can get a sense of where inflation stands and where it may be headed.
As it pertains to investing, inflation can impact asset classes in a variety of ways:
- Rising prices can lead to strong equities valuations, while a sudden spike in inflation can send stock prices tumbling.
- High inflation can prompt monetary policy moves or economic downturns. Forex investors must be aware of these factors as they pertain to their target currency pair.
- Commodities typically show strength during inflationary cycles and may be used to hedge against broader market risks.
Due to the risks posed by inflation, investors may want to consider maintaining diversified portfolios. By incorporating a variety of unique holdings, it is possible to reduce the negative impacts of inflation while capitalising on the upside potential of rising prices.
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