Intermediate

Fundamental analysis

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Inflation

2.5-minute read

Inflation is a crucial factor in economics and plays a key part in fundamental analysis. Let’s take a closer look at what inflation, hyperinflation and deflation all really mean.

As we covered in the previous lesson, central banks must maintain a tricky balancing act. Most have a dual mandate of maintaining high employment while keeping prices stable – and to keep prices stable, you need to manage inflation.

What is inflation?

Inflation is the term for when prices rise over time in an economy. It gets its name because prices are being inflated higher each year, just like blowing up a balloon.

While rising prices might seem like a bad thing, they are part of a growing economy. Most economists today believe that a low and stable inflation rate can help reduce the severity of economic downturns by providing a cushion against falling prices, which can be difficult to manage if they become entrenched.

For this reason, central banks will try to keep inflation within acceptable parameters. The Bank of England, for example, has a target of 2%. This means that prices overall should increase by 2% each year.

If inflation drops below 2%, it may consider lowering interest rates to boost the economy and get it back on track. If it goes too high, they could raise rates to slow the economy. Otherwise, they run the risk of hyperinflation.

Illustration showing example of interest rates vs inflation dynamics

Hyperinflation

Hyperinflation occurs when inflation gets out of control. Prices get too high, and the value of currency plummets. Classic examples include Germany before WW2, Russia after the fall of the Soviet Union and Zimbabwe in the mid-2000s.

Hyperinflation trend illustration on FOREX.com course on inflation

Usually, hyperinflation leads to a total loss of confidence in an economy and its currency, so central banks are constantly on the watch to avoid it. Some analysts argue that the rise in unconventional monetary measures – such as quantitative easing – in the 2010s could lead to hyperinflation by flooding the market with capital.

Deflation

Deflation arises when prices are declining – so inflation is below 0%.

To the average person on the street, deflation might seem like a good thing. Who wouldn’t want the things they buy every day to get cheaper?

Well, manufacturers and producers, for one. Deflation means that the margin they make from sales would go down, which hurts their bottom line and may lead to layoffs. As unemployment rises, demand falls, and companies are hurt even more. And what does this lead to? Even more job losses.

This is called a deflation spiral.

To avoid this spiral, central banks may consider easing monetary policy when inflation falls.

Illustration of FOREX.com UK trading academy showing factors relating to deflation on the FOREX.com inflation lesson.

Reflation and disinflation

These describe changes in the inflation rate:

  • Reflation is when the inflation rate is going up
  • Disinflation is when it is going down

In the 1990s and 2000s, the Bank of Japan struggled to reverse a stubborn disinflation trend. During this period, inflation remained low and the economy stagnated in a period known as the ‘lost decades’.

0% interest rates failed to kickstart consumerism or business activity, with the BoJ eventually turning to quantitative easing, in which a central bank buys bonds and asset-backed securities to increase money supply and introduce inflation.

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Test your knowledge

Question 1 of 3
How can QE increase inflation?
  • A By raising interest rates
  • B By increasing money supply in the economy
  • C By lowering demand for bonds
Question 2 of 3
A loaf of bread costs 50% more today than it did 20 years ago. Is this an example of…
  • A Inflation
  • B Deflation
  • C Hyperinflation
Question 3 of 3
A loaf of bread costs 500% more today than it did yesterday. Is this an example of…
  • A Inflation
  • B Deflation
  • C Hyperinflation