Inflation explained: definition, causes and current inflation rates
FOREX.com June 28, 2021 11:04 AM
Inflation affects consumers, economies and financial markets in diverse ways. Discover what inflation is, how it impacts consumers and the effect it can have on your trading positions or investments.
The links below take you to the specific inflation topics.
- What is inflation?
- What is an inflation rate?
- What is CPI?
- Is inflation good or bad?
- What causes inflation?
- What is inflation measured by?
- How inflation gets controlled
- How inflation reports affect stock markets
- How inflation reports affect forex markets
- What is the current inflation rate in the UK?
- What is the current inflation rate in the US?
- What is the current inflation rate in the EU?
What is inflation?
Inflation is the overall rise in the price levels of an economy over a set period, resulting in reducing the purchasing power per unit of money.
Inflation causes a loss of real value in the medium of exchange and unit of currency within an economy. When price levels rise, each currency unit buys fewer services and goods. This means you’ll spend more to put petrol in your car, buy groceries or get a haircut. In short, it increases your cost of living.
The standard measure of inflation is the inflation rate, the annualised percentage change in a general price index. Usually, the consumer price index referred to as the CPI, is the standard measure of inflation.
Learn about other macroeconomic indicators.
Economists contend that sustained inflation occurs when a nation’s money supply growth outpaces its economic growth.
As a currency loses value, prices rise, and consumers buy fewer goods and services. This loss of purchasing power affects the general cost of living for the public, leading to a reduction in economic growth.
Higher inflation can encourage short-term spending; consumers might buy goods before prices rise quickly. But savers eventually see the value of their savings erode, reducing their ability to spend or invest.
If inflation suddenly rises in a country, stock markets might sell-off. The domestic currency might also be affected if investors and traders believe the central bank might raise interest rates and reduce the money supply to limit the rise.
What is an inflation rate?
An inflation rate measures the increase or decrease of inflation over a period, ordinarily year-on-year. The metric gets used by many government departments to decide pay rises and welfare benefits for retirees.
Central banks will use the inflation figures they receive from closely linked stats agencies to set interest rates and manage the money supply in their economy.
The main inflation number can obscure crucial details and large month-to-month swings in various goods and services, so agencies who compile inflation statistics weigh the impact of multiple goods and services based on our usage.
Policymakers often focus on core inflation by excluding certain goods and services, like food and energy prices, because they can be volatile.
What is CPI?
Consumer price inflation (CPI) indicates when goods and services bought by households rise or fall in price. It is the most widely used measure of inflation.
Imagine a massive shopping basket containing many of the most popular goods and services bought by households. As the prices of the assorted items in the basket change over time, so does the basket’s total cost. Movements in the CPI represent the changing cost of the basket.
The ONS gives a percentage weighting to the items in their basket. For example, housing and household services occupy 32.8% of the basket, transport 10.7% and alcohol and tobacco 3.5%.
The basket will change to mirror changing consumer buying habits. In April 2021, 17 items were added to the CPI basket, including owner occupiers’ housing costs (CPIH) and 10 items were removed.
Additions to the basket included electric and hybrid cars, hand gel, men’s loungewear bottoms and smartwatches. Restaurant sandwiches bought at work and gold chains were two items taken out.
Is inflation good or bad?
In some ways, as consumers, we’re conditioned to fear breaking news of rising inflation, but governments and central banks try to generate a sweet spot for inflation. A core inflation rate of 2% is what the Federal Reserve and Bank of England aim to hit.
A moderate amount of inflation is a sign of a healthy economy; as the economy grows, demand increases. This demand pushes prices higher as suppliers try to create more of the things consumers and businesses purchase.
Workers benefit from controlled and moderate inflation because economic growth drives an increase in demand for labour, so wages usually rise.
Workers with higher wages can buy more, and this virtuous cycle keeps the economy growing moderately. Inflation in this context is a symptom of a growing economy.
If inflation is too high or too low, a damaging economic cycle can appear. If left unchecked, inflation could spike, and unemployment can increase as economic growth slows. Stagflation is the term used to describe the combination of high inflation and unemployment.
What causes inflation?
Inflation is caused by two main economic phenomena: demand-pull inflation and cost-push inflation.
Demand-pull inflation occurs when consumers have more disposable income. Having more spare money to spend allows people to afford more products and services. Expansionary fiscal and monetary policies and consumers expecting future price increases can also increase demand.
Cost-pull inflation occurs when the supply of goods and services decreases, creating a shortage. Producers will then raise prices to meet the increasing demand for their goods or services and cover their extra expenses.
Wage increases, changes in government fiscal policy, and central bank monetary policy and currency exchange rates often decrease supply in relation to demand.
What is inflation measured by?
The US Bureau of Labor Statistics (BLS) uses the Consumer Price Index (CPI) to measure inflation in the United States, 23,000 businesses get surveyed to compile the metric, and the prices of 80,000 consumer items are monitored for changes each month.
Other statistics agencies such as the UK’s ONS (Office for National Statistics) use similar surveys and formulas to establish the CPI figure.
Around 180,000 separate price quotations are currently collected every month by the ONS to compile the indices, covering over 720 representative consumer goods and services.
These prices are collected from 140 locations across the UK, from the internet and over the phone. In addition, around 300,000 quotes get used measuring owner occupiers’ housing costs each month.
How inflation gets controlled
Central banks globally use their monetary policy powers to avoid both high inflation and deflation.
In August 2020, the FOMC (Federal Open Market Committee) announced it would target a CPI inflation rate of more than 2% to maximise employment opportunities. Still, the Fed said it was willing to allow higher inflation rates if inflation stayed lower.
The Fed uses the core inflation rate as its benchmark after taking out food and energy prices. These prices are derived from commodities markets and considered too volatile to put in the CPI.
How inflation reports affect stock markets
Reports of rising inflation can affect stock markets, especially if the inflation figure is outside of the targets set by a central bank or if inflation suddenly spikes month-on-month or quarterly.
Investors and business owners might fear high inflation in an economy. It can cause a chain reaction leading to rising interest rates and a cut in demand.
Any increase in interest rates by a central bank pushes up borrowing costs for corporates, and the lower demand for their goods and services will hurt growth in revenues. Sentiment for specific stocks, sectors and the stock market as a whole will be affected.
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When inflation spikes, returns on stocks tend to reduce, the earnings can be affected, and dividends might get reduced at some time down the line.
An increase in interest rates to lessen the impact of higher inflation causes investors to focus on other potentially high-yielding investments, such as bonds, commodities or forex. These investments are considered less risky during inflationary periods.
When inflation is falling, central banks can lower interest rates to stimulate the economy by adding liquidity to markets. The lower interest rates also encourage investors to take their funds from high-interest rate yielding securities like bonds.
How inflation reports affect the forex market
Inflation reports are considered high-impact news releases on economic calendars. News of rising and falling inflation in an economy can have a dramatic and immediate impact on the value of a currency versus its peers.
For example, suppose core inflation is rising rapidly in the US economy. In that case, FX traders and investors might believe the Federal Reserve has the capacity and motivation to raise interest rates to ensure the US economy doesn’t overheat.
A rise in interest rates is good for the value of the US dollar. The USD (US dollar) should rise if traders and investors think an interest rate is on the cards.
Investors can also get returns on dollar deposits through the carry trade if interest rates rise - using currencies from countries with lower interest rates to invest in currencies with higher interest rates.
What is the current inflation rate in the UK?
The Consumer Prices Index (CPI) rose by 0.7% in the 12 months to March 2021, up from 0.4% to February 2021. CPI rose by 0.3% in March 2021, compared with little change in March 2020.
The Consumer Prices Index, which includes owner-occupant housing costs (CPIH), rose by 1.0% in the twelve months to March 2021, up from 0.7% to February.
The most significant upward contribution to the CPIH 12-month inflation rate came from transport (0.44 percentage points).
Rising prices for motor fuels and clothes caused an upward contribution to the CPIH 12-month inflation rate change between February and March 2021, partially offset by falls in food price.
The CPIH rose by 0.2% in March 2021, compared with little change in March 2020.
What is the current inflation rate in the US?
According to the US Bureau of Labour Statistics, the Consumer Price Index for All Urban Consumers (CPI-U) increased 0.8% in April on a seasonally adjusted basis after rising 0.6% in March.
During the last twelve months, the all items index increased 4.2% before seasonal adjustment, the biggest 12-month increase since a 4.9% increase for the same period ending September 2008.
The used cars and trucks index rose by 10.0% in April, the largest single-month increase since the series began in 1953. This rise accounted for a third of the seasonally adjusted all items increase.
The food index increased in April, rising by 0.4% as the indices for food at home and other venues increased. The energy index decreased as a decline in the index for gasoline in April offset any increases in the index for natural gas and electricity.
Except for food and energy, the index for all items rose 0.9% in April, the biggest monthly increase since April 1982. Just about all significant component indices rose in April.
Indices for shelter, airline fares, recreation, motor vehicle insurance, and household furnishings and operations were separate indices affecting the overall index increase.
What is the current inflation rate in the EU?
According to the preliminary estimate published in April, the Eurozone consumer price inflation was 1.6% year-on-year in April of 2021, the highest level since April 2019 and in line with market expectations.
Energy prices should rise by 10.3% (4.3% in March), with non-energy industrial goods costs up 0.5% (0.3% in March).
Slower increases are expected for services at 0.9% (1.3% in March) and food, alcohol & tobacco (0.7% vs 1.1%).
The annual core inflation, excluding volatile energy, food, alcohol and tobacco prices, which the ECB (European Central Bank) looks at for its policy decisions, is expected to slow to 0.8% in April from 0.9%.
In summary, inflation, if managed carefully, can lead to sustained periods of healthy growth in an economy. Wages can rise, employment remains high while investors and savings can see respectable returns. If inflation increases quickly, central banks have various levers at their disposal to get it under control.
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