What inflation is and why the inflation rate matters to traders

Investors consider many factors when making decisions on where to allocate their money. One crucial factor is the economic well-being of the country where they wish to invest. To determine an economy's performance or health, they consider several data points, including the unemployment rate, consumer and business confidence, interest rates, and inflation. Ideally, they want to invest in a country that creates jobs, has a high confidence rate, and controls inflation.

What is inflation?

Inflation is a situation where the price of products is rising. As the rate of inflation increases, the underlying value of the local currency declines. For example, if you have $100, you can buy a full shopping basket in a local store. If the rate of inflation increases by 5% in one year, the $100 will fill only 95% of your shopping basket when you go shopping.

As a result, according to the inflation calculator provided by the U.S. Bureau of Statistics, a $100 note in 2000 had a buying power of $150 in September 2018, and a $100 note in 1950 had the same buying power of $1074 in September 2018.

Moderate, stable inflation is considered healthy for an economy because it often reflects growing demand. In such an environment, companies may be able to raise prices and maintain profitability, which can support business expansion and job creation.

The opposite of inflation is known as deflation. It is a situation where the price of products is declining. For example, if the price of gasoline falls by $10 in one year, consumers can use the savings to buy other things. However, a steep deflation rate is dangerous to an economy because companies will make less profit per unit, have challenges paying their debts, and then lay off workers, increasing the national unemployment rate.

Another essential concept is hyperinflation, which occurs when a country's monthly inflation rate rises by more than 50%. This is a dangerous situation because it causes the local currency to lose value and makes ordinary products unaffordable.

Finally, there is the concept of stagflation. It is a situation where a country's economic growth slows, accompanied by a growing unemployment rate and a high inflation rate. This is common in oil-exporting countries and happens mostly when crude prices rise. This leads to slow growth in these countries and high product prices. The latter comes as the rising oil prices lead to high transportation and production costs.

Types of inflation

Let's explore different kinds of inflation. Knowing about these types is like figuring out the rules of a global game. Once you know them, it's easier to understand what's happening in the economy.

Demand-pull effect

Demand-pull inflation occurs when demand for goods and services outpaces the available supply.

In simple terms, when many people want to buy something but there isn't enough of it, sellers can raise prices because consumers are willing to pay more. This typically happens when the economy is strong, and more people have stable jobs and higher incomes. With more money to spend, people tend to buy more of the things they want, driving up demand across the board.

For example, imagine a new gaming gadget is released, and it becomes hugely popular. If demand for the gadget rises by 3%, but the manufacturer can only increase production by 2%, there won't be enough to meet everyone's needs. As a result, the price goes up because people compete to get one. To meet the growing demand, the company may need to hire more workers, which creates jobs and puts even more money into the economy. As spending continues to increase, it can push prices up further.

Cost-push effect

The cost-push effect refers to a rise in prices that happens when the cost of producing goods and services increases.

This can happen when the costs of materials, labour, or other resources rise, so it becomes more expensive for companies to make things. Businesses raise their prices to cover these higher costs, which can lead to overall inflation in the economy.

If the prices of ingredients like vegetables or meat go up, the restaurant will charge you more for your favourite meal to cover those costs. Suppose energy (like gas or electricity) and materials (like metal or wood) become more expensive. In that case, everything we buy can cost more.

If your favourite coffee shop raises the price of coffee because the coffee beans are more expensive, that's called cost-push inflation. This means that prices increase because the shop spends more to make coffee.

Now, if many people still want to buy that coffee even though it's more expensive, that leads to demand-pull inflation as discussed above.

Built-in inflation

Built-in inflation is a cycle that occurs when people expect prices to keep rising in the future.

As the cost of goods and services goes up, people need more money to afford their usual expenses. In response, workers may ask for higher wages to keep up with the rising cost of living. When businesses raise wages, their production costs increase. To maintain profits, they may raise prices again—leading to even higher inflation. This cycle of rising wages and prices can continue if inflation expectations persist.

For example, imagine you earn $500 a week, and that normally covers your food, clothes, and entertainment. But if prices start to rise, your $500 won't go as far. You might then expect your employer to give you a raise so you can afford the same things. When many workers ask for higher pay and businesses respond by increasing prices, built-in inflation takes hold.

When prices go up, people respond by asking for higher wages to keep up with those rising costs. Ultimately, this creates a cycle in which everything keeps getting more expensive.

Advantages and disadvantages of inflation

While inflation is often viewed negatively, moderate inflation can have several benefits for the economy.

• When prices gradually rise, people are more likely to spend money now rather than wait, since their money will buy less in the future. This encourages consumer spending, which helps businesses grow and supports overall economic activity. If everyone were to hold off on spending in anticipation of falling prices, businesses would earn less, potentially leading to job losses.
• Inflation can also be helpful for people who owe money. For example, if you borrow $10,000 today, that debt becomes easier to repay over time as the value of money declines. In effect, you’re paying it back with ‘cheaper’ dollars. This is especially beneficial for long-term loans like mortgages—your monthly payment stays the same while your income and the value of your property may rise.
• Governments also benefit from inflation. As prices increase, sales taxes (which are based on purchase prices) generate more revenue. For instance, if an item that used to cost $60 now costs $70, the government collects more in taxes from each sale. This additional income can be used to fund public services like education, healthcare, and infrastructure.
• Finally, when people expect prices to rise, they may rush to make purchases sooner, boosting demand. This can lead businesses to expand and hire more workers to meet the increased demand, helping to reduce unemployment and stimulate job growth.

Here are the drawback of inflation:

• Inflation becomes a problem when prices for everyday goods—like food, clothing, and housing—rise faster than people's incomes. This reduces purchasing power, meaning people can buy less with the same amount of money. It hits low-income households the hardest, as they spend most of their earnings on essentials, leaving little room to adjust when prices rise.
• When inflation increases, workers often ask for higher wages to keep up with the cost of living. But if businesses can’t produce more goods or services to match rising demand, they may raise prices further instead—fueling a cycle of even higher inflation.
• High or unpredictable inflation also makes it harder for businesses to plan for the future. Uncertainty about costs and prices can lead to reduced investment and slower economic growth. In fact, countries with persistently high inflation often experience weaker long-term economic performance.
• Inflation can also hurt a country’s global competitiveness. If prices rise too quickly compared to other nations, exports become more expensive, making it harder for domestic businesses to sell their products abroad.
• Savers are affected too. Inflation erodes the value of money over time, meaning savings lose purchasing power—especially if interest earned doesn’t keep pace with inflation. This can be particularly difficult for retirees or others living off fixed savings.
• Government bonds, which are essentially loans to the government, also lose value during high inflation. Investors demand higher interest rates to offset the impact, which makes borrowing more expensive for the government.
• Finally, when inflation gets too high, governments may be forced to take strict measures—like raising interest rates or cutting spending—to bring it under control. These actions can slow the economy, cause job losses, and even lead to a recession in the short term.

Causes of inflation

There are several causes of inflation. These include:

• Money supply expansion. When a country's central bank increases the money supply, more money chases the same amount of goods and services, leading to higher prices. A dramatic example of this is Zimbabwe, where excessive money printing in an attempt to stimulate growth led to hyperinflation and the collapse of the local currency’s value.
• Monetary policy. It refers to the decisions made by central banks to manage the economy, often through interest rates and money supply control. Lowering interest rates encourages borrowing and spending, which can increase inflation. Conversely, tightening policy (by raising rates) helps control inflation. Central banks can also devalue their currency to boost exports, but this may lead to higher prices for imported goods, contributing to inflation.
• Increased taxation. Governments sometimes raise taxes on goods and services to fund public spending or reduce deficits. These tax hikes, such as value-added tax (VAT) or excise duties, are often passed on to consumers in the form of higher prices, contributing to inflation.
• Demand and supply dynamics. Prices naturally fluctuate based on supply and demand. If demand for goods or services outpaces supply—such as during shortages of key commodities like crude oil—consumer prices can rise. These supply shocks can trigger inflation even without changes in consumer behavior.
• Economic growth. Strong economic growth can also lead to inflation. As more people find jobs and incomes rise, consumer spending increases, which can drive up prices. This relationship is often illustrated by the Phillips Curve, which suggests that inflation tends to increase as unemployment falls, due to greater demand in the economy.

Important measures of inflation

To learn the rate of inflation, traders can use the economic calendar. In the calendar, they look at several financial indicators. These are:

• Consumer Price Index (CPI). This number shows the average change in the price of goods and services in an economy.
• Core CPI. This number shows the change in the average price of goods and services while excluding volatile energy and food products.
• The Producer Price Index (PPI). It measures the change in the prices of goods received by domestic producers.
• Retail Sales. These numbers show the growth of retail sales in the country. Increasing sales indicates that the rate of inflation is likely to move up.
• Employment numbers. The Phillips curve compares the inflation rate to job numbers, as described above. As employment improves and the unemployment rate falls, inflation is usually expected to increase.

Why the inflation rate matters to traders

To traders, the inflation rate is significant when deciding whether to buy or sell a currency. This is mainly because central banks influence a country's interest rates.

One role of the central bank is to ensure the price stability of products in a country. Therefore, when the rate of inflation increases, the central bank often raises interest rates to limit the overall money supply. This is because more people and companies will avoid borrowing with high rates. When this happens, the local currency strengthens as its supply becomes limited.

On the other hand, when the inflation rate falls, the central bank tends to lower interest rates. They do this to make money readily available to people and companies, leading to more spending and a higher inflation rate. However, this only sometimes happens. For example, after the financial crisis 2008/9, the Bank of Japan lowered rates to increase inflation. When it failed to happen, the bank decided to push rates to the negative territory. Even after doing that, the country continued to experience slow inflation growth despite the improvement in economic growth. This is mainly because most Japanese prefer saving to consumer spending.

Therefore, traders pay close attention to a country's inflation rate because of the central bank. The local currency of a country whose inflation rate is rising tends to strengthen because traders usually anticipate tightening from the central bank. Similarly, a country's currency with low—and falling—inflation tends to remain lower because it is almost impossible for a central bank to tighten under these conditions.

How to trade using interest rates

If you specialise in fundamental analysis, the inflation rate is very important, and you can use it in many ways.

First, when the jobs numbers show a falling unemployment rate and a general improvement in employment, traders believe that this will lead to a high rate of inflation, which will lead to high interest rates. High interest rates can lead to a stronger currency and higher bond yields. Higher bond yields, on the other hand, lead to lower stock prices as investors rotate from stocks to bonds. In this case, you can buy the country's currency and short the country's stocks and indices.

Second, inflation numbers create opportunities for carrying trade opportunities. A carry trade strategy involves borrowing money at low interest rates and using the funds to buy a better-yielding asset. Forex works by buying a currency with low or negative interest rates and using the funds to buy a better-yielding currency. The goal is to earn the spread in interest rates and see the value of the currency they purchase rise. A good example of a good pair for carrying trades is the USDJPY. This is because the U.S. federal funds were at 2.25% in September 2018 while the BOJ rates were at minus 0.1%.

Third, if the central bank still needs to provide forward guidance on interest rates, the CPI and PPI numbers can help you forecast future rate hikes. If the CPI shows continued inflation growth, it indicates that the central bank will likely raise rates. Alternatively, if the CPI numbers are decreasing, the forecast is lower interest rates. With this knowledge, you can buy the local currency if you believe its value will rise or short it if you think it will decline.

Inflation numbers as an opportunity

A good thing about the Forex market is that you can short (sell) currency pairs. When you buy a currency pair, you are hoping that the value of the base currency will increase against the quote currency. When you short, you expect the base currency's value to decrease. Therefore, the inflation numbers can help you make an informed decision about the future of the currency pairs.

Final thoughts

• Inflation is when prices go up, meaning your money doesn’t buy as much as it used to.
• Investors watch inflation closely because it affects the economy and where they choose to invest their money.
• If inflation gets too high—called hyperinflation—money can quickly lose its value, making everyday items too expensive.
• If prices drop too much, a situation known as deflation, businesses may earn less and start laying off workers.
• Inflation can be caused by things like printing too much money, rising production costs, or higher taxes on goods.
• Understanding how inflation works helps investors make better decisions about where to put their money.