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Here’s What You Need to Know About Inflation

Plus500 | Wednesday 30 March 2022

One of the most talked-about economic effects of monetary policies adopted in the COVID-19 era has been rising inflation rates across the developed world. In order to fully grasp the economic headwinds facing many advanced economies, it’s important to understand why inflation happens, and how it influences the behaviour of governments and traders alike.


What is Inflation?

The so-called ‘ideal’ rate of inflation, as defined by central bank economists, is about two percent per year. This is to say, in times of healthy economic growth, prices of a range of consumer goods will be about 2% more expensive every year.

However, inflation can increase at rates beyond this measure because of phenomena both on the production and supply sides of the economy. If the costs of producing certain goods go up, due to supply chain issues or shortages, for example, manufacturers may pass the costs on to consumers, causing a price increase. 

Conversely, when demand for certain goods hits an uptrend, prices may rise in tandem. If a certain nation’s supply of credit or money allows citizens to increase consumption beyond the marketplace’s ability to supply goods, the increased demand and limited supply raise prices.

The flipside of consumer goods rising in price is that it is accompanied by a decrease in the value of a nation’s currency. When products rise in price, each unit of monetary value is able to purchase fewer goods. For example, if it cost $40 for a consumer to fill up their car’s gas tank last year, but due to a rise in Oil prices it now costs $60 to purchase the same quantity of petroleum, the value of their salary has declined, as it is now able to afford them less gas. This is where monetary policy, usually determined by central banks like the Federal Reserve or Bank of England, comes in.

Inflation and Monetary Policy

As aforementioned, most central banks set an annual inflation rate of around two to three percent as their target. An exceedingly low rate of inflation, or even deflation, when prices are falling, can be taken as a sign of weak macroeconomic conditions in a country’s economy. This phenomenon can be observed when supply outpaces demand, caused by more consumers choosing to save rather than spend, or by increased production spurred by lower input costs. Falling prices can also lead to declining wages.

On the other hand, when inflation rises above the target range, wages can struggle to keep up, making it hard for citizens to maintain their standard of living. In conditions of hyperinflation, prices rise by 50% or more over the course of a month, often stimulated by external shocks such as geopolitical conflict as well as excessive money printing by central banks. In times of hyperinflation, basic goods needed for an economic activity like Wheat (ZW) or Oil can become scarce. 

Accordingly, central banks use the tools at their disposal in order to maintain price stability, a steady rise in prices that neither falls into deflation nor rises into hyperinflation. While in the past, monetary authorities often printed money in order to directly influence money supply on the national economy, today’s central banks prefer to use what are called ‘open market operations’, or the buying and selling of government bonds. For example, throughout the course of the coronavirus pandemic, the Federal Reserve purchased large quantities of government bonds so as to support the American economy.

When a central bank moves to buy government bonds from private market actors, the money supply is increased. The inverse is true when monetary policymaking bodies like the Federal Reserve decide to sell their government bond holdings. Central banks are especially prone to attempt to increase the money supply in times of reduced economic activity, such as that experienced in the wake of the COVID-19 pandemic.

Why Inflation’s Happening Now

Throughout the course of the now more than two years since the coronavirus first led to lockdowns across the globe, central banks have mostly hewed to a so-called ‘dovish’ monetary policy, using the tools at their disposal to stimulate the domestic economy. In the United States, for example, the Federal Reserve kept interest rates low to avoid economic crisis as wide swathes of the marketplace were paralyzed by infection containment measures.

However, the emergency measures keeping interest rates ultra-low contributed to the current conundrum facing American policymakers, and the Federal Open Market Committee’s (FOMC) decision calculus has shifted. The economy was so stimulated by the Fed’s ‘easy money’, low-interest rate policies that consumer demand rose too quickly for supplies to keep up. Shipping lines around the world simply couldn’t get goods to market fast enough, and producers raised prices to profit from increased demand.

In recent months, inflation in the United States has continually broken records, with year-over-year price rises the highest seen since the first Reagan administration. Accordingly, the Federal Reserve has seen fit to begin a series of interest rate hikes so as to rein in inflation. Some analysts even predict that American interest rates could be raised by half a percentage point following each of the FOMC’s next four meetings, a step not taken by the U.S. central bank since 2000. 

With Oil (CL) prices also on an upswing since the Russia-Ukraine conflict and Western sanctions have raised fears of supply disruption, those looking at inflation may now have additional cause for concern. Crude is a key input in a variety of manufacturing processes, so producers tend to pass the rise in petrol prices on to the consumer when Oil demand rises. Inflation is commonly observed in the aftermath of a steep rise in Oil’s cost per barrel. According to Federal Reserve Chair Jerome Powell’s Senate testimony in March of 2022, inflation rises by one-fifth of a percentage point every time that Oil rises by $10 in its price per barrel on average. Economic analysts in the European Union have also raised the prospect of record-high inflation, or even a recession, fueled by Russian petroleum supplies to Europe being cut off.

How Might Traders Respond?

In times of economic uncertainty and inflation, traders have historically tended to invest in sectors seen as safer. For example, Commodities like Gold (XAU) and Silver (XAG) are sometimes called safe-haven assets, due to the fact that they often show price gains in inflationary environments as investors see these precious metals as safer stores of value than national currencies. When inflation rises more quickly in one country than another, the currency of the former becomes worthless. For example, when inflation is high in the U.S. but lower in Japan, the Forex pair EUR/USD will rise as the greenback drops in value.

Furthermore, Indices themselves often shift in response to changing macroeconomic conditions and monetary policy. Interest rate hikes, often implemented to tame inflation, generally lead to a slowdown in economic growth. Tech and growth stocks, defined as those which grow more quickly than industry averages, are especially vulnerable to higher interest rates’ effects on their bottom line. This is because traders are more likely to invest in venerable firms with proven, reliable cash flows when interest rates rise. Accordingly, Indices like the tech-heavy Nasdaq (US-Tech 100) may experience downturns following a tightening of monetary policy.

Conversely, value stocks, defined as those with low share prices relative to their business fundamentals, tend to be less affected by interest rates, as investors positively rate the likelihood of receiving a return on their investment when compared to other stocks. Firms like Citigroup (C) and Unilever (ULVR-L) have been named by many analysts as value stocks, so they may stand to be less negatively impacted by the Fed’s hawkish turn.

Much is still up in the air when it comes to inflationary pressures currently dominant in the United States and other major economies. Whether central banks will succeed in taming runaway price increases as geopolitical tensions rise, and how trading floors from Hong Kong to Manhattan will respond, is yet to be determined.

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