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What is inflation and how does it work?

Inflation is an increasingly pressing issue – not only for consumers, but traders too. Find out more about what inflation is, what really causes it and ways to hedge against inflation.
Trader
Source: Bloomberg

What is inflation?

Inflation is the lessening of a currency’s purchasing power in an economy and, as a result, it’s also synonymous with rising costs of living. When inflation rises, the same amount of money is worth less than it used to be.

This means buying the same things costs more because the value of the money itself has dropped, so it takes more money to buy the same items.

Because inflation makes money worth less, it’s problematic for any non-inflation linked investment as it can lower the real value (i.e. the purchasing power) of those returns.

Causes of inflation

Inflation is usually measured within a country, and the causes of it domestically are the same as most economics: supply and demand. However, inflation rarely happens within a single country in isolation. Instead, there are a wide variety of global economic factors at play.

Often, a major world economy (the US, for example) will increase inflation for macroeconomic reasons, which can then have a domino effect on many other currencies in the world causing inflation in those countries as well.

There are several factors that might lead to this:

  • Demand-pull inflation
  • Cost-push inflation
  • Devaluation
  • Undersupply due to scarcity
  • Oversupply of money itself
  • Built-in inflation

1. Demand-pull inflation

When there’s rapid economic growth, there’s a greater demand for money in all regions. Infrastructure spend is up, wages for workers increase, consumers buy more goods and so on. It can lead to the demand for money outgrowing the supply of that currency, which often means that country will need to print more money.

Couldn’t this mean money is worth less because there’s more supply? Not usually. This is because the amount of items that economic growth demands – e.g. more goods for shoppers, more materials for infrastructure construction – are likely still the same. This causes the price of those supplies to increase as demand increases. So, a given amount of money can still purchase less than it did before.

This same logic can also apply to foreign exchange – any export, import or service that a country’s economy is highly dependent upon can be affected if there’s suddenly more demand than there is supply. For example, if a country is dependent on grain produced by another country but a drought causes a scarcity, this could lead to inflation in both countries as that commodity is more expensive.

Find out all about foreign exchange

2. Cost-push inflation

Rather than scarcity pulling costs up, production prices increasing can push inflation too. If a currency is dependent on certain goods and services for GDP growth, changes to pricing for their production or delivery processes can lead to inflation.

For example, if oil drilling is a significant source of revenue for a country, anything that causes higher costs associated the drilling process could cause inflation. This could be higher wages or increases in the cost of drilling equipment.

3. Devaluation

Unlike the first two causes of inflation, which are caused by macroeconomic circumstances, devaluation is a decision made by the government to lower the value of their currency so it’s worth less than before.

An emerging market country may do this to make its exports more attractive, generally increase international trade in and out of the country and also potentially lessen its national debt deficit. By making itself ‘cheaper’ through devaluation, they can attract more buyers for whatever exports they’re selling in the international marketplace.

However, devaluation often causes inflation if other currencies haven’t changed their value, so the cost of importing goods is higher for that country than it was before ultimately leading to its money being able to buy less.

4. Undersupply due to scarcity

Sometimes, literal scarcity can drive down the value of money. If, for example, a country is hit by devastating natural disasters or war which makes basic items very hard to come by, then the price of these items can naturally rise. This consequently makes the money of that country worth far less, as it costs more to buy the same goods.

In these extreme situations, investor behavior can also compound inflation. An example would be if a country’s citizens anticipate so much instability that they withdraw savings and other assets and hoard these items to avoid losing them if the banking system were to see turbulence. This would also lead to a shortage of assets in an economy, further driving up inflation in a vicious cycle.

5. Oversupply of money itself

The opposite of the cost-pull scenario we mentioned earlier is when there’s more money circulating in an economy than there’s a desire to spend. Several things could lead to this, like a decrease in taxes (meaning more cash in hand for citizens) or a widespread country culture of saving rather than spending.

As per the economic principles of supply and demand, the value of that money will go down if there’s a greater amount of money available in a financial system than there is a demand for it.

6. Built-in inflation

When any of the above causes of inflation persist for a long time, that can become the country’s ‘new normal’. This leads what’s known as built-in inflation – where the effects of inflation are part of a continuous cycle.

For example, prices of goods tend to rise regularly. As a result, the country’s working class demands higher wages to pay for the higher cost of living. This increases their disposable income, which leads to a rise in the demand for consumables – again increasing their prices. This is the most common cause of inflation today.

Extreme examples of inflation

While there are some positive side effects of inflation, there are times when it’s so extreme that it creates a snowball effect – runaway inflation – which can lead to a phenomenon called hyperinflation.

This panic, combined with excessive and unmanageably high costs of everyday goods, has left its mark on some of the most pivotal eras in the past century.

The hyperinflation in Germany, 1923

Germany’s currency, the deutschemark, had weakened drastically and the country was in considerable debt after the First World War. To make matters worse, political instability was rife and the country had come off the gold standard, which meant its currency was no longer backed by the reliable anchor of the current gold price. The precarious Weimar Republic started printing more money hoping to help.

By 1922, Germans had begun to trade goods in a kind of bartering system to avoid using the increasingly meaningless deutschemark. At hyperinflation’s zenith in 1923, in forex, one US dollar was equivalent to one trillion deutschemarks.

The 1973 oil crisis

After the Yom Kippur War in 1973, the countries of the Organization of Arab Petroleum Exporting Countries (OAPEC, now known as OPEC, the Organization of Petroleum Exporting Countries) retaliated by placing an oil embargo on the countries which had supported its adversary, Israel.

These included many of the most influential nations in the world: the United States, United Kingdom, Canada, the Netherlands and Japan. Many countries imported the vast majority of their oil from OPEC, so this shock to the financial system led to runaway oil prices.

The embargo lasted for almost six months, during which the price of petrol increased by over 200%. Particularly in the United States, it was so volatile that the fuel price would sometimes change more than once a day. This led to significant inflation of household goods for American citizens and had a domino effect on the global economy.

The 2022 Russian invasion of Ukraine

Shortly after the devastating effects of the Covid-19 pandemic, citizens of the Ukraine woke to the sounds of gunfire and explosives on 24 February 2022. Russia, under its president Vladimir Putin, had launched a full-scale military strike on the country.

Most of the international community imposed sanctions quickly to cut off any funding of the conflict. However, this also led to a spike in global inflation, as the rest of the world was deprived of the oil, grains, exported goods and rubles that Russia had previously supplied. The EU and in particular Germany was affected severely, being deprived of their vital gasoline pipeline Nord Stream 2.

With the invasion lasting more than eight months, it caused prices for petrol and diesel, as well as for most food stuffs and other household goods, to increase significantly throughout 2022 – hamstringing vulnerable countries just after the devastation of the pandemic and worsening poverty in developing economies.

Effects of inflation

  • Erosion of purchasing power
  • The poor become poorer
  • Interest rates rise

1. Erosion of purchasing power

Inflation means that the money used to buy items or services is worth less, and things effectively cost more than they used to. The same groceries, fuel or other items are more expensive, so people have to make their unit of currency stretch that much further to meet their needs reducing their disposable income and effectively their buying power.

2. The poor become poorer

It’s not all bad for those who own assets that appreciate in price when inflation hits. Things like property, certain companies’ share prices, pension funds and investments in some commodities often act as useful hedges against inflation – because of interest rate increases (see below) the value of these things rise with inflation, offsetting the fact that monetary value of cash itself has depreciated.

This means that those on the less wealthy side of the spectrum, who don’t own property or these sorts of investments, tend to be hit hardest by inflation.

3. Interest rates rise

As we’ve seen in our earlier examples of hyperinflation, too much inflation can have a devastating effect. To prevent this from happening, central banks will usually raise interest rates to curb inflation. They’ll use monetary policy to constrain the supply of money and drive the borrowing costs (i.e. the interest rate) higher.

There are a number of reasons for this. When inflation causes a currency to lose some of its purchasing power, the bigger money lenders such as banks will demand a raise in interest rates – the amount of interest which they are allowed to charge borrowers and the amount of interest they themselves pay back to the central bank – as compensation for the loss of worth in the money itself.

However, a more important reason is staving off further inflation. When interest rates go up, loans, mortgages and other forms of bonds become more expensive. This curbs too much borrowing, and therefore too much spending. This leads to consumers buying less or cheaper where they can, which aims to drive down the prices of these goods – thereby keeping purchasing power in check.

How to measure inflation

There are two different ways to measure inflation: the first is CPI (Consumer Price Index) and the second, lesser used one is RPI (Retail Price Index). While other methods do exist, CPI and RPI are the most common.

With CPI, inflation is measured by looking at the current price of consumable goods in shops as compared to what the same items used to cost.

While this is some indication of inflation, RPI is more comprehensive, as many things affected by inflation aren’t on shelves in stores (for example property prices, the cost of services and more.) While CPI focuses on consumables, RPI also measures the difference in the retail prices of things such as property, mortgage interest rates and insurance premiums.

Both RPI and CPI measure inflation by looking at the rate of increase of prices under their purview. While RPI is broader and takes into account more than just store goods, CPI is more inclusive. This is because a smaller percentage of most populations tend to have properties, insurance and investments.

Advantages and disadvantages of inflation

ADVANTAGESDISADVANTAGES
The value of assets like property, certain bonds and some commodities (e.g. gold) can appreciateCash’s purchasing power is decreased
Controlled inflation can be good for an economy as it prevents deflationThe poor and middle class are increasingly squeezed by rising costs
Inflation without interest rate increases can be good for debtorsInflation without interest rate increases is bad for lenders like banks

How inflation gets controlled

How inflation is controlled will vary from country to country. In the United States, for example, inflation largely depends on macroeconomic conditions, but can be controlled by the Federal Reserve (known as the FOMC), which is the country’s central bank.

If inflation needs to be controlled, the US Federal Reserve will use monetary policy to raise or lower the country’s interest rates. The FOMC will raise them to try and curb inflation when it’s high, and lower interest rates when needed to try and stimulate growth, employment and spending in a depressed environment. This will in turn have a knock-on effect that either corrals or stimulates inflation.

How to hedge against inflation

Hedging means opening a trade or investment that you think will be profitable to mitigate short-term losses of an existing position you have open without your having to close it. You can hedge against inflation by opening a trade in an asset class known to perform well when inflation rises (certain currency pairs in forex, for example) so as to offset inflation risk. Keep in mind that past performance

What is inflation risk?

Inflation risk is the chance that uncontrolled inflation, arising from macroeconomic circumstances rather than deliberate monetary policy changes, will lessen the purchasing power of that country’s money raising the risk that the worth of any investments or cash you own will be eroded.

How inflation impacts wages

In most countries, the service sector is a significant contributor – if not the largest industry outright – to an economy. For this reason, how high or low wages are set very much affects inflation.

When workers are paid more, the cost of many industries goes up as they must pay higher wages. This can often cause inflation – known as wage push inflation – because it’s that much more expensive for industries to do business.

However, this can quickly lead to a vicious cycle if left unchecked. That’s because, if higher wages lead to higher inflation, this can in turn mean more expensive goods and services. When these prices rise, workers tend to demand higher wages to keep up with the increasing cost of living.

Inflation summed up

  • Inflation is the decreasing of money’s purchasing power as the cost of consumables like goods and services rises
  • It can make a country’s unit of money worth less, effectively, as you can buy less with the same amount
  • This can result in economic problems for the lower and middle classes, although some assets like property, some bonds and commodities can appreciate
  • Inflation is caused either by macroeconomic factors like the supply and demand for money or by a central bank’s monetary policy
  • You can hedge against inflation by trading or investing in forex markets like certain currency pairs that tend to perform well when inflation rises. Keep in mind that past performance may not be indicative of future results.

Sources:
1European Central Bank, 2022
2 The New York Times, 2022

Footnotes
1 Based on revenue (published financial statements, October 2022).

This information has been prepared by tastyfx, a trading name of tastyfx LLC. This material does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. You should not treat any opinion expressed in this material as a specific inducement to make any investment or follow any strategy, but only as an expression of opinion. This material does not consider your investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. No representation or warranty is given as to the accuracy or completeness of the above information. tastyfx accepts no responsibility for any use that may be made of these comments and for any consequences that result. See our Summary Conflicts Policy, available on our website.