Inflation causes prices to rise over time, which reduces the value of money. It varies in intensity across different regions, so it affects savings and investments in diverse ways. That is why understanding inflation is key to effective financial planning and economic decisions.
What is inflation?
Inflation is the rise in prices for goods and services, which impacts our cost of living. The Consumer Price Index (CPI) measures this by tracking what we pay for everyday items. The Producer Price Index (PPI) looks at price changes from the sellers’ and manufacturers’ perspective.
Most people talk about inflation in terms of the CPI because it shows the overall cost of living. However, economists look at core inflation to understand the real trends. Core inflation excludes the fluctuating prices of food and energy and gives a clearer picture of the economy’s steady inflation.
Inflation is caused by several factors.
- Demand. When demand for goods and services surges, prices rise (demand-pull inflation). Strong domestic demand attracts foreign investors, increasing domestic currency demand and leading to currency appreciation.
- Costs. Rising production costs, like wages and raw materials, drive up prices (cost-push inflation). Countries facing cost-push inflation become less competitive in trade, which leads to currency depreciation.
- National debt. High national debt prompts governments to print more money, potentially increasing inflation. High debt combined with inflation concerns reduce investor confidence and lead to currency depreciation.
- Money supply. Increasing the money supply leads to inflation, while decreasing it helps control inflationary pressures.
Why does inflation matter for traders?
Inflation affects various asset classes differently. For example, stocks may perform well during inflationary periods if companies increase their prices to match rising costs. However, fixed-income investments like bonds can suffer because their fixed-interest payments become less valuable in real terms. Real estate and commodities perform well as hedges against inflation because their values tend to increase along with prices.
Inflation can also impact exchange rates. Countries with lower inflation rates usually see an appreciation in the value of their currency relative to countries experiencing higher inflation. This is because goods and services in the low-inflation country become relatively cheaper, increasing interest in its currency.
From a trading perspective, if you think one country will have lower inflation than another, you can buy the country’s currency with lower inflation. That way, when inflation rates differ, you may trade currencies on the Octa platform, a globally recognised financial broker since 2011, and potentially profit from the difference in their values.
Moreover, inflation data provides clues about what central banks might do next with interest rates. When inflation is high, central banks often raise interest rates to slow down spending and investment, which helps reduce inflationary pressures. Conversely, during low inflation or deflation periods, central banks usually lower interest rates to stimulate borrowing and spending.
How can traders use information on inflation?
1. Higher rates hurt stocks.
When interest rates rise, businesses’ borrowing costs increase, reducing profitability. For example, if a company has loans or bonds with variable interest rates, its interest payments will increase and potentially reduce earnings. Also, higher rates can deter consumers from borrowing, leading to lower consumer spending and decreased business activity. During the inflation shock of 2022–2023, stocks saw major volatility as investors reacted to changes in interest rates and inflation expectations.
2. Bonds lose value.
Because new bonds are issued with higher interest rates, existing bonds with lower rates become less attractive to investors. Therefore, the market value of existing bonds decreases, causing bond prices to fall. For instance, if an investor holds a bond with a fixed interest rate of 3% and new bonds are issued with a rate of 5%, the investor can sell their bond at a discount to match the higher yields offered by new bonds.
3. Rising interest rates strengthen the currency.
When a central bank increases interest rates as a response to inflation, it attracts the interest of foreign investors looking for higher returns. This increased interest in the country’s currency increases its value. For example, if the U.S. Federal Reserve raises interest rates, investors will acquire more U.S. dollars, strengthening the dollar against other currencies.
4. Higher interest rates dampen demand for commodities.
Rising interest rates dampen overall economic activity, but certain commodities like oil and gas act as hedges against inflation. During periods of high inflation, investors can allocate more capital to commodities as a store of value. For example, during the inflation shock of 2022–2023, oil and gas prices experienced serious increases because investors sought to protect their assets against inflationary pressures.
Conclusion
Inflation can have short-term benefits, like boosting wages and stimulating growth, especially in a strong economy. But if inflation persists, it eats into people’s savings and reduces their purchasing power. To counter this, investing in solid companies offering essential goods and government bonds is smart during inflation.
Traders and investors need to monitor inflation indicators and central bank actions to anticipate their effects on markets. Plus, if you know how a specific event affects exchange rates, you can take advantage of it quickly.
