How Inflation Works and Why Traders Must Understand It

3 Sep

Inflation has become one of the most important topics in modern economics because of its recent prominence, affecting forex pairs, commodities, as well as everyday goods and services. In this post, our team will provide educational clarity on inflation, what it means, and the important definitions to understand whether you're new to markets or a savvy pro who needs a quick refresher on the topic.

Before we get to the exact calculation of inflation, let us first go over the terms you need to know. By understanding the exact terms surrounding inflation, you’ll have a solid foundation to think critically about the topic.

5 Inflation Terms to Know

1. Inflation occurs when prices rise over time. Think of it like blowing up a balloon – prices get bigger when inflation expands. While it might seem bad, a low and stable inflation rate is good for the economy. Central banks, like the Fed or the Bank of England, aim to keep inflation around 2% to keep stability.

2. Hyperinflation happens when inflation gets out of control, causing prices to skyrocket and currency to become devalued. Examples include Germany before the Second World War and Zimbabwe in the 2000s. Central banks work hard to prevent it.

3. Deflation is the opposite – prices fall. While it sounds good, it can lead to job losses and economic decline, creating a deflation spiral. Central banks may lower interest rates to counteract this.

4. Reflation and disinflation describe changes in the inflation rate. Reflation occurs when inflation rises, and disinflation happens when it falls. Japan faced disinflation in the 1990s, leading to economic stagnation.

5. Zinflation is when inflation stays the same. It sounds stable but can show a lack of economic growth.

Now that you understand the terms that surround inflation, you are ready to dive into the exact calculations of inflation. It’s crucial to understand that inflation is calculated based on specific economic reports for the CPI or Consumer Price Index, which measures a basket of goods like milk and other essentials. Economists calculate inflation by looking at the prices in the CPI report and then comparing those prices to prior periods. For example, if prices are going up in the CPI compared to last year, we know inflation is rising.

Why is CPI Important?

CPI reports are used by central banks to make decisions about interest rates. If CPI is rising too quickly, it usually points to inflation, and the central bank might raise interest rates to cool down the economy. Conversely, if CPI is falling, central banks might lower interest rates to stimulate spending.

CPI is related to inflation. When CPI increases, it suggests that inflation is occurring, meaning the purchasing power of money is decreasing. This is why central banks monitor CPI closely to ensure that inflation stays within a target range, typically around 2-3%. As a trader or investor, you can use these numbers to better understand how asset prices trade relative to inflation.

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---Forex.com Team